Treatment of community income for spouses living apart.

EXECUTIVE SUMMARY

* Under Sec. 66(c), traditional relief can be granted for deficiencies due to omitted income items, while equitable relief can apply to any deficiency or unpaid tax.

* For traditional relief, the requesting spouse must establish that he or she did not know, and had no reason to know, of the income item.

* Rev. Proc. 2003-61 specifies the five threshold requirements for Sec. 66(c) equitable relief and a nonexclusive list of factors that the IRS should consider if the threshold requirements are met.

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Sec. 66 provides reporting and liability relief for married, but separated, taxpayers living in community property states. Part II of this two-part article explains and illustrates the requirements for traditional and equitable relief under Sec. 66(c).

This two-part article offers guidance on Sec. 66 relief to practitioners with married clients who are separated and reside in community property states. Part I, in the March 2006 issue, discussed relief from the community property laws under Sec. 66(a), and how the IRS has the power to deny the benefits of the community property laws under Sec. 66(b). Part II, below, explains and illustrates Rev. Proc. 2003-61 (34) and the Sec. 66(c) regulations, which provide traditional or equitable relief to spouses in certain cases.

Traditional and Equitable Relief

If a spouse seeking relief from the effects of the community property laws does not qualify under Sec. 66(a), relief may still be possible under Sec. 66(c) and Regs. Sec. 1.66-4. There are two types of Sec. 66(c) relief--traditional and equitable. Under Regs. Sec. 1.66-4(c), traditional relief is available only for deficiencies arising out of omitted items of income. Equitable relief, however, can be granted for any deficiency or unpaid tax (or any portion of either), as long as it was not paid as of July 22, 1998 or arose thereafter.

Traditional Relief

Four conditions must be met to qualify for traditional relief." (35)

1. The spouse did not file a joint return;

2. The spouse did not include an item of community income in gross income that would be treated as the income of the other spouse under Sec. 879(a);

3. The spouse establishes that he or she did not know, and had no reason to know, of the item of community income; and

4. After examining all of the facts and circumstances, it would be inequitable to include the item of community income in the spouse's gross income.

The first two conditions are straightforward. Proposed regulations required the requesting spouse to have filed a separate return for the year in question. (36) The final regulations, however, require only that he or she did not file a joint return. (37) Under the second condition, if the requesting spouse filed a return, it could not include an item of community income that would be attributed to the nonrequesting spouse under Sec. 879(a). (38)

The third and fourth conditions are much more subjective. Under the third condition in Regs. Sec. 1.66-4(a)(1)(iii), the requesting spouse must establish that he or she did not know, and had no reason to know, of the item of community income. This regulation is straightforward in denying relief if the requesting spouse had actual knowledge of the item of community income. However, the answer is less clear when the issue is whether the requesting spouse had a "reason to know" under Regs. Sec. 1.66-4(a)(2)(i). This is determined by a "reasonable person" standard--would a reasonable person in similar circumstances have known of the item of community income. All relevant facts and circumstances must be considered, including:

* The nature of the item of community income;

* The amount of the item in relation to other income items;

* The couple's financial situation;

* The requesting spouse's education and business experience; and

* Whether the item was included on the couple's prior returns.

Nature and amount: If the requesting spouse knows the nature of the item but not the specific amount, he or she has the requisite knowledge or reason to know. (39) The IRS maintains that this is consistent with the case law--if a spouse knows of the community income-producing activity but not the amount, a reasonably prudent person would determine the amount of community income earned during the year in question. (40) However, if the requesting spouse does not have actual knowledge of the income-producing activity, reason to know should not be attributed to the requesting spouse unless he or she benefited from the item of community income. (41)

The IRS's insistence on ignoring the requesting spouse's ability to determine the amount of community income may allow an unscrupulous nonrequesting spouse to avoid being taxed on all the community income he or she earned. As long as the requesting spouse knows the source of the community income (e.g., employment, business or investment), knowledge sufficient to defeat Sec. 66(c) traditional relief is attributed to the requesting spouse, even if the nonrequesting spouse refuses to inform the requesting spouse about the amount of the community income and refuses to share the income. The result presumably is the same even if the nonrequesting spouse is simply behaving badly. For example, if the nonrequesting spouse refuses to speak or exchange information with the requesting spouse due to anger, knowledge will be attributed to the requesting spouse as long as he Or she has knowledge of the income-producing activity. And, in most marriages, it is likely that each spouse knows of the other's business activities. Such situations could have been avoided if the regulation had put more emphasis on the requesting spouse's ability to determine the amount of community income. Of course, if the nonrequesting spouse has refused to notify the requesting spouse of the amount, he or she may be subject to Sec. 66(b) action if he or she also acted as if solely entitled to the income. (42)

Facts and circumstances: The fourth condition for traditional relief requires that it be inequitable to include the item of community income in the requesting spouse's gross income after taking into account all facts and circumstances. (43) Relevant factors include desertion, divorce or separation. The most difficult issue for many requesting spouses is whether they benefited (directly or indirectly), from the omitted item of community income. "Benefit" includes normal support, but not de minimis amounts. (44) The final regulations are more stringent than the proposed regulations in this regard. Under the proposed regulations, the relevant factor was whether the requesting spouse "significantly" benefited directly or indirectly from the income omitted. A significant benefit was any benefit in excess of normal support. (45) The final regulations bring the standard more in line with that of Sec. 66(c)'s legislative history (i.e., "whether the requesting spouse benefited from the untaxed income"). They also follow case law interpreting Sec. 66(c). (46) For example, in Beck, (47) the Tax Court found the requesting spouse had "benefited" from her husband's dental practice income. She had made significant deposits of dental practice income into her separate bank account and used it to purchase property. The court looked to Sec. 66(c)'s legislative history and only inquired whether she "benefited" from the untaxed income; it made no effort to determine whether the benefit was in excess of normal support. In Hardy, (48) the Tax Court found that a spouse had benefited from the untaxed income, because her husband had used at least a portion of it to pay some of his wife's living expenses. It is possible to argue that the standard used in Hardy was actually "less than normal" support.

Timing of request: The earliest a request for traditional relief can be submitted is the date the requesting spouse receives an audit notice or a letter from the Service stating the possibility of an outstanding liability. The latest date is six months before the statute of limitations on the nonrequesting spouse's tax year in question. (49)

Equitable Relief

The final sentence of Sec.66(c) establishes the basis for equitable relief."

Under procedures prescribed by the Secretary, if, taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either) attributable to any item for which relief is not available under the preceding sentence, the Secretary may relieve such individual of such liability.

A major feature of Sec. 66(c) equitable relief is that the requesting spouse may be relieved of any unpaid tax liability or deficiency; even deficiencies and underpayments of tax arising from disallowed deductions or credits are eligible. Other Sec. 66 relief applies only to omitted community income items. Equitable relief is available only for the unpaid portion of liabilities as of July 22, 1998, or those liabilities arising after that date. (50) The earliest an equitable relief request can be submitted is the date the requesting spouse receives an audit notice or a letter from the Service stating the possibility of an outstanding liability as to the year in question. (51) The final regulations defer to Rev. Proc. 2000-15 (52) or other applicable guidance for the relevant factors. (53)

Rev. Proc. 2003-61 was issued shortly after the final regulations were issued and supersedes Rev. Proc. 2000-15. It sets the thresholds for Sec. 66(c) equitable relief and provides a nonexclusive list of circumstances considered for requests of relief from Federal income tax liability or deficiency resulting from the community property laws. (54)

Thresholds

Under Rev. Proc. 2003-61, there are five thresholds a requesting spouse must meet for consideration of equitable relief under Sec. 66(c).

Two-year requirement: First, the requesting spouse must apply for relief no later than two years after the first collection activity. (55) This does not include a deficiency notice, Notice of Federal Tax Lien or a demand for payment of tax. The two-year clock begins once the Service issues a Sec. 6330 notice, offsets a requesting spouse's overpayment against a liability under Sec. 6402, files a suit against the requesting spouse for the collection of the joint tax liability, or files a claim in a court proceeding in which the requesting spouse is a party or which involves a requesting spouse's property. (56)

No-transfer requirement: Under the second threshold requirement, the spouses must not have transferred assets between them as part of a fraudulent scheme. (57) Third, the requesting spouse cannot have received a disqualified asset from the nonrequesting spouse. (58) A "disqualified asset" is any property or right to property transferred to the requesting spouse if the principal purpose was the avoidance of tax or payment of tax. There is a presumption that any transfer of property from the nonrequesting spouse made within one year before the date on which a 30-day letter was mailed, or, if no 30-day letter was mailed, the date on which a notice of deficiency was sent, is a transfer of a disqualified asset. The presumption also applies to property transferred after the mailing date of the first letter of a proposed deficiency. However, it is rebuttable if the transfer was pursuant to a divorce or separate maintenance decree, part of a property settlement related to a divorce or had a principal purpose other than the avoidance of tax or payment of tax. (59)

Other requirements: Fourth, the requesting spouse must not have filed or failed to file the return, with a fraudulent intent. (60) Fifth, the requesting spouse must be requesting relief from a tax liability attributable to an item of the nonrequesting spouse unless: (61)

* The item is attributable or partially attributable to the requesting spouse solely due to the community property laws; (62)

* The item is rifled in the name of the requesting spouse, but the requesting spouse can rebut the presumption that the income is attributable to him or her.

Example: C opens an IRA in M's name without her knowledge, forges her name and makes contributions to the account for several years. In 2004, C takes a distribution from the IRA. M should be able to rebut the presumption that the IRA income is attributable to her, even though it is nominally in her name. (63)

* The requesting spouse can establish that the nonrequesting spouse (for his or her own benefit) misappropriated funds intended for the payment of tax without the requesting spouse's knowledge. (64)

* The requesting spouse can establish he or she did not challenge the treatment of any items due to fear of retaliation based on abuse that occurred before the return was signed. (65)

Rev. Proc. 2000-15 originally contained the first four thresholds; whether the liability was attributable to the nonrequesting spouse was a factor to be considered once the other threshold requirements were met. Under Rev. Proc. 2003-61, the fifth threshold requirement now incorporates that factor.

Equitable Relief Factors

If the requesting spouse meets all of the thresholds, the Service will then take into account all facts and circumstances. Rev. Proc. 2003-61 provides a nonexclusive list of factors the Service is to consider.

Marital status: The question is whether the requesting spouse is legally separated, living apart or divorced from the nonrequesting spouse. Temporary absences (e.g., military service, incarceration, education, illness and the like) do not qualify as living apart as long as the return of the absent spouse to the household can be reasonably anticipated. The test for determining whether two spouses are members of the same household is the same as that in the regulations. (66)

Economic hardship: The question is whether the requesting spouse would suffer economic hardship if relief is not granted. Under Kegs. Sec. 301.6343-1(b)(4), (67) a requesting spouse may suffer economic hardship if paying the tax liability would cause an inability to pay his or her reasonable basic living expenses. Basic reasonable living expenses should take into account the unique circumstances of each requesting spouse, but in no case may it support an affluent lifestyle. The Service considers age, employment status, ability to earn, dependents, status as a dependent on another's return and the reasonable funds necessary for food, clothing, housing, medical expenses, transportation, current tax payments, alimony, child support and expenses related to the production of income. The requesting spouse also may provide information on property owned, the cost of living in a geographical area, extraordinary circumstances (e.g., special education expenses, a medical catastrophe or a natural disaster), and any other factor that may bear on economic hardship. If the requesting spouse fails to act in good faith, such as by inflating expenses, the Service may refuse to reach a finding of economic hardship. (68)

Knowledge or reason to know: Under Rev. Proc. 2000-15, the requesting spouse's actual knowledge or reason to know of the item giving rise to a deficiency or that a reported liability would not be paid, weighed heavily against granting relief. (69) However, under Rev. Proc. 2003-61, the heavy weighting is applicable only to actual knowledge of an item giving rise to a deficiency. Actual knowledge of a tax liability that was not paid, a reason to know of a tax liability that was not paid and a reason to know of an item giving rise to a deficiency are now not weighted any heavier than any other factor. (70) Determining whether the requesting spouse had reason to know is similar to that of whether the requesting spouse had a reason to know of an item of community income under Sec. 66(c) traditional relief. (71) Relevant factors include the requesting spouse's level of education, the degree of involvement in the activity generating the tax liability, the business or financial expertise of the requesting spouse, and unusual or lavish expenditures in the year in question in comparison to the past. Also considered is whether the nonrequesting spouse was deceitful or evasive, and how involved the requesting spouse was in business and household finances. (72) Rev. Proc. 2003-61 also implies that a reasonable person standard will apply as under Sec. 66(c) traditional relief.

Nonrequesting spouse legal obligation: A nonrequesting spouse's legal obligation to pay the tax liability under a divorce decree or agreement generally favors relief. However, it may not be viewed as positive if the requesting spouse knew or had reason to know that the nonrequesting spouse would not pay the liability at the time of the decree or agreement. (73)

Significant benefit: The requesting spouse's receipt of a significant benefit from the tax liability or the item giving rise to the deficiency is considered a factor weighing against relief. (74) It is interesting that the Service chose to adopt the "significant benefit" standard of the superceded proposed regulations, (75) instead of the more stringent "benefit" standard under final Sec. 66(c) traditional relief regulations. (76) A significant benefit is any benefit in excess of normal support. Evidence of a direct or an indirect benefit may be transfers of property or rights to property, including those received several years after the year of the understatement. (77) Kling (78) provides a good illustration of the more lenient significant-benefit standard. The spouse did not receive a significant benefit, even though she had a joint interest in an account into which her husband had deposited funds from his unreported sports memorabilia sales, as she only used the account to buy groceries and other items for normal family support. The couple's lifestyle did not change, and there were no extraordinary property transfers to the wife. Under the more stringent "benefit" standard, a spouse had benefited from the untaxed income because her husband had used at least a portion of the income to pay some of her living expenses. (79)

Compliance with tax laws: The requesting spouse's good-faith attempt to comply with the tax laws in years subsequent to the year or years at issue is considered favorably. Conversely, failure to comply is viewed negatively. (80) In Beck, (81) the Tax Court found that the requesting spouse had not made a good-faith effort to comply with the tax laws when she persistently failed to comply with the rules and orders of the court and failed to cooperate with the Service in preparing the case for trial.

Abuse and mental illness: Matters of abuse and mental illness favor granting equitable relief if they are present, but will not weigh against them if they are absent. (82)

Knowledge or reason to know may be mitigated if the requesting spouse can show a history of abuse. (83) As actual knowledge of an item giving rise to a deficiency is a factor heavily weighted against granting equitable relief, a showing of abuse may result in a finding of equitable relief that would not otherwise be available.

A requesting spouse's poor physical or mental health when he or she signed the return or at the time relief was requested is a factor. The nature, extent and duration of the illness is taken into consideration. (84)

Example: A and M have been married for 20 years and reside in a community property state. A is a high school business teacher and M is a family physician who operates her own practice as an individual proprietor. They intend to divorce and have lived apart for the past two years. Over the years, M has had taxable income from her practice ranging from $125,000 to $315,000. In prior years, A helped M with billing, collections, accounting and preparing information for their accountant, who prepared a joint return for them. For each of the past two tax years, A filed a married filing separately return, reported all the income he earned from teaching ($42,000 in year 1 and $45,000 in year 2) and paid all taxes due.

A asked M to provide him with taxable income from her practice in both years, but M refused. The ongoing divorce proceedings have been acrimonious, and M refuses to provide A (or his divorce attorney) with any information regarding her finances. M has even been found in contempt of court for not fully complying with discovery requests and ordered to provide financial information.

Despite the judge's rulings, M has failed to produce the requested financial information. Without A's knowledge, M filed married filing separately returns in year 1 and year 2. In each year, she claimed one-half of the taxable income from her practice ($240,000 x 0.5 = $120,000 in year 1, and $315,000 x 0.5 = $157,500 in year 2) and one-half of A's wages ($21,000 in year 1 and $22,500, in year 2). M had actual knowledge of A's wages from his response to discovery proceedings in the divorce action.

In year 1 and year 2, M paid A's rent of $800 for the two summer months that A did not receive a paycheck from his teaching position. In August of year 3, A received notice from the Service that his year 1 return would be audited.

A will probably not be entitled to relief under Sec. 66(a) or traditional relief under Sec. 66(c). He is disqualified under Sec. 66(a) because M indirectly transferred a portion of her earned income to him when she paid his rent for two months. The $1,600 is too large to qualify for the de minimis exception.

A cannot qualify for traditional relief under Sec. 66(c) for two reasons. First, he would be considered to have reason to know of M's income because he knew of the source or activity generating it (in fact, he helped M account for the income in prior years). Not knowing the exact amount is insufficient to absolve him of the knowledge criteria. Second, M's payment of A's rent for two months is likely to be interpreted as A benefiting from the untaxed income.

Equitable relief: A's prospects for equitable relief under Sec. 66(c) are brighter. Under Rev. Proc. 2003-61's threshold requirements, he has two years from the start of collection to apply for relief. At this point, no collection activity has commenced. An application for relief is not premature if it is filed after the August audit notice. It appears that A meets the remaining threshold requirements as well. There is no indication of a fraudulent transfer or a transfer of a disqualified asset. A did not file the return in question with fraudulent intent. Finally, the tax liability from which he is requesting relief is attributable to an item of income associated with M.

Because A meets all the thresholds, the Service will then consider all of the facts and circumstances (as provided in Rev. Proc. 2003-61) in determining whether to grant equitable relief. For example, A and M are living apart. Because M is retaining the income from the practice, it would be an economic hardship to require A to pay tax on $141,000 that he had no access to, instead of the $42,000 he reported. Moreover, A does not have actual knowledge of the income because he does not know the amount. (Actual knowledge would be an extremely strong factor against granting equitable relief.) A does have reason to know of the income but this does not disqualify A's eligibility for relief (as with traditional relief), because it is only one negative factor to be considered along with all other factors. Because A and M still are married, M is probably not under a court order to pay the tax liability in question; thus, legal obligation is probably not applicable. A did not receive a significant benefit when M paid his rent for two months because such benefit would have to be a benefit in excess of normal support--two months of rent compared to all the costs associated with A's support would probably not be considered in excess of normal support.

One possible question is whether A made a good-faith effort to comply with the tax laws in the year subsequent to year 1 by filing his married separate return and reporting all of his teaching income in year 2. The Service could contend that A knew he was not in compliance with the tax laws when he did not report half of M's income. It also is possible that, due to M's refusal to provide A with information, the IRS would conclude that A was making a good-faith effort to comply with the tax laws by filing the year 2 return and including all of his teaching income.

Of the seven factors, three (marital status, economic hardship and significant benefit) favor granting equitable relief. One factor (knowledge) weighs against granting relief, and one (compliance with the tax laws) is unclear. Two factors (legal obligation and abuse or mental illness) are inapplicable. Based on a preponderance of facts and circumstances in his favor, it appears that A should be granted equitable relief.

Conclusion

Sec. 66 provides an avenue for married taxpayers in community property states to separately report and pay tax on community income in certain situations. Sometimes a qualifying request for relief can avoid a horrific financial situation for a requesting spouse. Sec. 66 is a not a panacea, however. The requirements for relief under the final regulations and Rev. Proc. 2003-61 are stringent. However, with special attention and thoughtful analysis, practitioners can help their clients obtain the benefits while avoiding the pitfalls lurking within these provisions.

For more information about this article, contact Dr. Karnes at [e-mail].

(34) Rev. Proc. 2003-61, 2003-2 CB 296.

(35) See Regs. Sec. 1.66-4(a)(1).

(36) See Prop. Kegs. Sec. 1.66-4(a)(1)(i).

(37) See Regs. Sec. 1.66-4(a) (1)(i). The change was made when a commentator noted that Sec. 66(c) requires only the requesting spouse not to have filed a joint return. Sec. 66(c)'s legislative history also supports this interpretation; see TD 9074 (7/10/03). Prior to this clarification, there was a split of authority on the issue in the Tax Court. Bobbie J. Roberts, TC Memo 1987-391, aff'd, 860 F2d 1235 (5th Cir. 1988), implied that the requesting spouse must file a separate return, but later cases did not require such a filing; see Patti Ollestadt, TC Memo 1996-139, and Sandra M. Costa, TC Memo 1990-572.

(38) See Kegs. Sec. 1.66-4(a)(1)(ii).

(39) See Kegs. Sec. 1.66-4(a)(2)(ii).

(40) Dorothy D. McGee, 979 F2d 66 (5th Cir. 1992), cited in Regs. Sec. 1.66-4(a)(2)(ii).

(41) Donna B. Hilton, TC Memo 1990-379 (holding that a spouse did not have reason to know of her husband's income from illegal activities because she had no actual knowledge of the activity and did not benefit from the illegal income).

(42) See discussion in Part I of this article in the March 2006 issue.

(43) See Regs. Sec. 1.66-4(a)(1)(iv).

(44) See Regs. Sec. 1.66-4(a)(3).

(45) See Prop. Regs. Sec. 1.66-4(a)(3).

(46) See Preamble, TD 9074 (7/10/03).

(47) Robert L. Beck, TC Memo 2001-198, acq. IRB 2002-49.

(48) Cathy Hardy, TC Memo 1997-97, aff'd, 181 F3d 1002 (9th Cir. 1999).

(49) See Regs. Sec. 1.664(j )(i).

(50) Preamble, TD 9074, note 46 supra; and Regs. Sec. 1.66-4(c).

(51) See Regs. Sec. 1.66-4(j)(ii).

(52) Rev. Proc. 2000-15, 2000-1 CB 447, superseded by Rev. Proc. 2003-61, 2003-2 CB 296.

(53) See Regs. Sec. 1.66-4(b).

(54) Rev. Proc. 2003-61, note 34 supra, at Section 1.01. This revenue procedure and its predecessor, Rev. Proc. 2000-15, note 52 supra, also applies to Sec. 6015(f), which provides equitable relief from joint and severable liability on a joint tax return (innocent spouse rule). Secs. 66(c) and 6015(f) have similar standards for granting equitable relief.

(55) Rev. Proc. 2003-61, note 34 supra, at Section 4.01(3).

(56) Property of the requesting spouse is property in which the requesting spouse has an ownership interest (other than solely through the operation of community property laws), including property owned jointly with the nonrequesting spouse; see Regs. Sec. 1.6015-5(b)(2)(i).

(57) Rev. Proc. 2003-61, note 34 supra, at Section 4.01(4).

(58) Id., at Section 4.01(5).

(59) See Sec. 6015(c)(4)(B); and Kegs. Sec. 1.6015-3(c)(3).

(60) Rev. Proc. 2003-61, note 34 supra, at Section 4.01(6).

(61) Id., at Section 4.01(7).

(62) Id., at Section 4.01(7)(a).

(63) Id., at Section 4.01(7)(b).

(64) Id., at Section 4.01(7)(c).

(65) Id., at Section 4.01(7)(d).

(67) Id., at Section 4.03(a)(i); and Regs. Secs. 1.66-2(c) and 1.6015-3(b)(i).

(67) Id., at Sections 4.03(a)(ii) and 4.02(1)(c).

(68) See Regs. Sec. 301.6343-1(b)(4) (as amended in 1994).

(69) Rev. Proc. 2000-15, note 52 supra, at Section 4.03(2)(b), superceded by Rev. Proc. 2003-61.

(70) Rev. Proc. 2003-61, note 34 supra, at Section 4.03(a)(iii).

(71) See Regs. Sec. 1.66-4(a)(2)(i).

(72) Rev. Proc. 2003-61, note 34 supra, at Section 4.03(a)(iii).

(73) Id., at Section 4.03(a)(iv).

(74) Id., at Section 4.03(a)(v).

(75) See Prop. Regs. Sec. 1.66-4(a)(3).

(76) See Kegs. Sec. 1.66-4(a)(3).

(77) See Kegs. Sec. 1.6015-2(d).

(78) Raymond Kling, TC Memo 2001-78.

(79) Cathy Hardy, note 48 supra.

(80) Rev. Proc. 2003-61, note 34 supra, at Section 4.03(a)(vi).

(81) Robert L. Beck, note 47 supra.

(82) Rev. Proc. 2003-61, note 34 supra, at Section 4.03(b).

(83) Id., at Section 4.03(b)(i).

(84) Id., at Section 4.03(b)(ii).

Allan Karnes, M.A., J.D., CPA 

KPMG Tax Research Professor

School of Accountancy

Southern Illinois University-Carbondale

Carbondale, IL

Scott Salmon, M.Acc., CPA

Partner

KPMG LLP 

Washington National Tax

Washington, DC

Darla Karnes, M.Acc., CPA

Instructor

School of Accountancy

Southern Illinois University-Carbondale

Carbondale, IL