Protecting innocent spouses.

The tax law provides limited protection to taxpayers whose spouses intentionally misstate their joint tax liabilities.

In many marriages, one spouse handles the couple's financial affairs, including preparation of joint income tax returns. But what happens if that spouse intentionally mis-states income or deductions and thus understates the couple's tax liability? Is the other spouse liable for any resulting taxes, interest and penalties? The Internal Revenue Code's innocent spouse provisions, combined with case law, provide relief in limited situations.

When a joint return is filed, IRC section 6013(d)(3) requires both taxpayers to be jointly and severally liable for any tax. Particularly after a divorce, one spouse may discover the other spouse reported taxable income incorrectly. Thus if taxes, interest and penalties are due, the innocent spouse is jointly and severally liable for the entire tax bill.

Section 6013(e)'s innocent spouse provisions were enacted to address situations in which an innocent person, in addition to the government, was misled by a spouse who incorrectly reported taxable income. The law provides relief when it is inequitable to expect the innocent spouse to pay interest and taxes.

The innocent spouse provisions were amended by the Tax Reform Act of 1984 to broaden the scope of relief. Recent cases suggest the Tax Court, supported by the Eleventh Circuit Court of Appeals, continues to restrict relief to very limited factual situations. The Second, Eighth and Ninth Circuit Courts of Appeals have interpreted the amendments more liberally. (The side-bar on page 65 outlines the geographic area these courts cover.) This article reviews the amendments and discusses the different standards applied by the courts.

THE OLD RULES

Before 1984, section 6013(e) established these criteria to be eligible for innocent spouse treatment:

* A joint return must have been filed and gross income omitted.

* The innocent spouse must establish that, in signing the return, he or she did not know of, and had no reason to know of, the omission.

* It must be inequitable to hold the innocent spouse liable for the tax deficiency. Such a determination must take into account whether the innocent spouse significantly benefited, directly or indirectly, from the omission.

This section generally was interpreted by the courts as applying to limited factual situations. Innocent spouse relief was available only when a court was convinced the innocent spouse had no knowledge of omitted income. Relief was not available when an innocent spouse was aware income had been omitted but did not understand its tax consequences.

THE NEW RULES

Congress broadened the scope of section 6013(e) in amendments to the TRA of 1984. In addition to omitted income, innocent spouse treatment was extended to cases of improper deductions, credits and cost-basis amounts. The amendments retroactively applied to all open tax years.

Under section 6013(e)(1), four conditions are required for innocent spouse relief:

1. A joint return must have been filed.

2. A substantial understatement of tax must be attributable to one spouse's grossly erroneous items.

3. The innocent spouse must establish he or she did not know, and had no reason to know, of the substantial understatement.

4. In light of the facts and circumstances, it is inequitable to hold the innocent spouse liable for the resulting taxes.

Section 6013(e)(2) defines grossly erroneous items as

* Any income items the culpable spouse omitted from gross income.

* Any deduction, credit or cost-basis claims by that spouse in amounts for which there is no basis in fact or law.

In at least two cases, appeals courts differed with the Tax Court interpretation of the third requirement--knowledge of the transaction. Both the Eighth and Ninth Circuits reversed the Tax Court's application of this requirement; the Second Circuit has indicated it will follow this interpretation. However, in a similar case, the Eleventh Circuit sided with the Tax Court in determining a wife had reason to know of a substantial understatement and did not qualify for innocent spouse treatment.

INTERPRETING THE KNOWLEDGE STANDARD

The Tax Court interprets the knowledge standard as it did before the amendment. For example, in Bokum (94 TC 126 [1990]), the court discovered the taxpayer was aware of the sale of a ranch. Although the transaction was included on the return, the tax treatment of the sale was eventually determined to result in a substantial understatement of the couple's tax liability. The court decided mere knowledge of the transaction was sufficient to preclude relief under section 6013.

This is a strict interpretation of the standard as it applies to cases involving deductions, credits or basis amounts. In most instances, if an innocent spouse examined a return before signing it, the deduction, credit or basis amounts on it provide enough information to put him or her on notice and require further inquiry. In such cases, the Tax Court generally will decide an innocent spouse has knowledge of a transaction and does not qualify for relief.

ELEVENTH CIRCUIT AGREES

The Tax Court applied the knowledge standard and denied relief to Madeline Stevens. The Eleventh Circuit (89-1 USTC para. 9330 [1989]) upheld the Tax Court decision and denied Stevens relief under section 6013(e) and held her jointly liable with her ex-husband for tax deficiencies exceeding $300,000.

In addressing the knowledge standard, the court only considered whether she had reason to know of the understatements, focusing on whether a reasonably prudent person who had sufficient knowledge of the facts underlying the claimed deductions would question them. In making its determination, the appeals court listed four criteria for applying the prudent taxpayer test:

1. The level of the innocent spouse's education.

2. The innocent spouse's involvement in financial affairs.

3. The couple's life-style. (Do expenditures appear lavish or unusual compared with past spending patterns?)

4. The culpable spouse's behavior. (Is he or she evasive or deceitful in handling the couple's finances?)

In Stevens, the court made the following observations:

1. Stevens had attended two years of college.

2. Stevens was not only an officer in her husband's corporation but also a secretary and bookkeeper. The court concluded she had unhindered access to the facts underlying the tax shelters that gave rise to the tax deficiencies. The couple discussed the pros and cons of various tax shelters periodically and she knew generally of the nature of the shelters he sold and in which he invested. Both spouses discussed their tax returns with their accountant, so she knew the losses claimed on the returns were attributable to tax shelters.

3. The court argued the couple's affluence when their tax returns reflected losses greatly in excess of income made the third criterion highly pertinent. The court had difficulty believing someone in Stevens's position would not question the accuracy of the tax liability on the returns.

The Eleventh Circuit said Stevens's participation in her husband's financial affairs and their lavish life-style should have given her reason to know the tax returns contained substantial understatements of tax liability. Thus, Stevens had reason to know of the substantial understatement and was not entitled to innocent spouse relief.

BROADENING THE STANDARD

In both Price (89-2 USTC para. 9598) and Erdahl (91-1 USTC para. 50,184) the taxpayers' ex-husbands reported incorrect deductions on their joint returns. Both Price and Erdahl noted the deductions on the returns, questioned their propriety and were assured by their husbands the deductions were proper. In Price's case, a CPA prepared and signed the return. In both cases, the Tax Court disallowed innocent spouse treatment because Price and Erdahl were aware of the deductions.

In reversing the Tax Court, the appeals courts referred to committee reports suggesting Congress had intended to expand innocent spouse treatment to excessive deductions and not to limit relief to unreported income (HR Rep. no. 432, 98th Cong., 2nd sess., at 1502). As in Stevens, these courts applied the prudent taxpayer test. But, contrary to Stevens, the women were allowed innocent spouse relief even though they were aware of the transactions that eventually resulted in additional taxes.

In Price, the Ninth Circuit applied the prudent taxpayer test in determining if Price had reason to know of the substantial understatement. Although Price was aware of a mining investment, her knowledge of the venture was limited. Since she was aware of the large deduction on the return, the Ninth Circuit examined the question of whether Price had reason to know of the substantial underpayment. In applying the prudent taxpayer test, the court found (1) Price had limited involvement in the family's financial affairs and no involvement in the mining venture, (2) there were no unusual or lavish expenditures during this period and (3) her husband took advantage of her lack of understanding and misled her. The Ninth Circuit concluded Price's awareness of the facts was not sufficient for her to know of the substantial understatement.

The court then considered whether her awareness of the facts would put her on notice such an understatement existed and would result in a duty to make further inquiry. According to the court, Price should have inquired further, but she satisfied this duty by questioning the deduction and receiving assurances it was proper. The Ninth Circuit concluded Price satisfied the prudent taxpayer test and was entitled to relief under section 6013(e).

In making this determination, the Ninth Circuit expanded the knowledge standard as it applied to deduction, credit and basis cases. The court concluded applying the same standard as in omission cases was overly restrictive.

In Erdahl, the Eighth Circuit agreed with the Ninth Circuit and concluded mere knowledge of a deduction did not preclude innocent spouse relief, but a spouse aware of a deduction had a duty to inquire further.

In Hayman, (93-1 USTC para. 50,272) the Second Circuit agreed with the Tax Court's denial of innocent spouse relief for various reasons. However, the court clearly indicated it would follow the knowledge test articulated in Price and Erdahl.

FINDING A SYMPATHETIC COURT

For a spouse to find relief under section 6013(e)'s innocent spouse provisions, he or she must meet all four of the requirements described in section 6013(e)(1). Many recent cases were decided based on the third requirement--that the innocent spouse establish he or she did not know, or have reason to know, there was a substantial understatement on a return. In many cases, this probably will be the condition on which the IRS and the courts focus when considering innocent spouse relief.

The Second, Eighth and Ninth Circuits have interpreted this requirement to apply when a reasonably prudent taxpayer can be expected to know a return contains a substantial understatement. The Eleventh Circuit says mere knowledge of a transaction eventually causing a substantial understatement fulfills this requirement. The Tax Court still applies the more restrictive standard in all districts except the Second, Eighth and Ninth circuits. Only in the Eleventh Circuit will that position be relatively certain to stand. With similar cases originating in other districts, the Tax Court will apply the more restrictive standard, although the appeals court for that district may require application of the less restrictive standard on appeal.

EXECUTIVE SUMMARY

* IF ONE SPOUSE INTENTIONALLY misstates income or deductions and understates a couple's joint tax liability, the other spouse may be jointly and severally liable for any resulting taxes, interest and penalties.

* INTERNAL REVENUE CODE section 6013(e) provides relief to innocent spouses who were misled if it is unfair to expect them to pay the additional taxes, interest and penalties.

* RELIEF UNDER SECTION 6013(e) is granted under four conditions:

1. A joint return must have been filed.

2. The tax must have been substantially understated due to one spouse's grossly erroneous items.

3. The innocent spouse must establish he or she did not know and had no reason to know of the understatement.

4. It is inequitable to hold the innocent spouse liable for the taxes in question.

* THE TAX COURT AND SOME circuit courts have not applied these conditions consistently. Granting relief often depends on the innocent spouse's level of education and involvement in financial affairs. Also of concern are lavish spending patterns in the face of large losses and the culpable spouse's evasiveness and deceit in handling the couple's finances.

* THE TAX COURT CONTINUES to apply a more restrictive standard except in cases that will be appealed to the Second, Eighth and Ninth appellate courts, which have been more liberal in granting relief to innocent spouses.

IT'S NOT WHAT YOU DO, BUT WHERE YOU LIVE

Based on recent decisions, applying the knowledge-of-the-transaction standard to innocent spouse cases often can be a matter of geography.

Cases originating in the Second, Eighth and Ninth Circuit Courts of Appeals generally are decided by applying the less restrictive knowledge-of-the-transaction standard. The Second Circuit includes Connecticut, New York and Vermont. The Eighth Circuit covers Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota. The Ninth Circuit includes Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, Washington and Guam.

Cases in the Eleventh Circuit, including Alabama, Florida and Georgia, generally are decided by applying the more restrictive knowledge standard.

DARLENE A. SMITH, CPA, PhD, is associate professor of accounting at the University of Tulsa, Tulsa. She is a member of the Am can Institute of CPAs, the Oklahoma Society of CPAs, the New Mexico Society of CPAs, the American Accounting Association and the American Society of Women Accountants.