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Becoming an innocent spouse. (Economic Observer).

EVERYONE THINKS the U.S. Tax Code was written just to raise revenue, but that's not really so. There are lots of sources of the agonies that you're put through each year. As author T.S. Elliot noted, "April is the cruelest month."

Many code provisions were drafted for economic stimulus. That's the reason for accelerated depreciation, investment tax credits, and "rate reductions" to put more cash into the economy. Others were created for social reasons. For example, there is the deduction for charitable donations to encourage contributions, "family friendly" provisions such as the child credit, and special tax breaks like the Coverdell education accounts and Section 529 plans to encourage savings for education. In another era, we might even have called these Code provisions "tax shelters."

Some Tax Code provisions are purely political. Do you think the "extra standard deduction" went only to the blind and not to the deaf because the "blind" lobby was stronger than the "deaf' lobby? Or, perhaps, someone whose vote was needed on another issue had a friend or relative (or maybe a big donor) who was blind?

The Tax Code is the last place I'd look for absolution. Nevertheless, once and a while, it comes up with a change that actually makes sense. The politicians must have missed this meeting, because the Tax Code now has a special provision that affords some long-needed protection to an "innocent spouse."

As a married man, I find the very concept of a truly "innocent" spouse slightly less probable than my winning the Irish sweepstakes. Nevertheless, if the IRS has an "Innocent Spouse" rule, I want to know how I can qualify. A little research dashed most of my hopes for absolute and universal absolution. The innocent part is real, but it just applies to Federal taxes--and only under certain limitations.

Here's my problem. If you're married and file a joint tax return, both of you are liable for any taxes due. The lawyers call it "joint and several" liability, which means that the IRS can go after both spouses or either one for the money owed. Let's say my wife is playing the stock market behind my back. She had a $10,000 short-term profit that she didn't tell me about. We file our tax return without showing the gain, and the agency's computer picks it up. As a result, I get a bill for $2,750 (in the 27.5% bracket) plus interest and penalties. Then, to bring complete joy and nirvana into my life, the IRS takes all the money out of my account. The "joint" part blessed me with the liability for her taxes, and the "several" part allowed the IRS to get the money from either of us.

Alternatively, assume that some time ago I put some money in a tax shelter and, over the years, we deducted the tax benefits from that investment. Unfortunately for us, that shelter gets audited and many of the deductions are disallowed. Since I filed a joint return with my spouse, she is personally on the hook for any money that I may owe. What if my wife and I divorced before the audit? This is meaningless to the IRS! It just wants the money, and they'll go after her if she has any.

Let's talk potential and real horror stories. A wife is abandoned by her husband, who runs off with all their money. Her wages are attached to pay his liability on an old joint return. Even though she never knew about his "secret" account nor got any cash from it, she still must pay the tax on the income.

In response to multiple public relations disasters, Congress provided legislative relief in the Omnibus Taxpayer Bill of Rights in 1988, followed by the Taxpayer Bill of Rights 2 in 1996 and the Taxpayer Bill of Rights 3 in 1998. Now, you can qualify as an "innocent spouse" and be relieved from liability from a deficiency on a joint return if you did not know about the understatement of tax, you had no reason to do so, and it would be inequitable to hold you responsible for the deficiency. The item at issue need not be grossly erroneous, nor does the understatement have to be substantial. Innocent spouse relief may be provided on an apportioned basis. In that case, you may be relieved of liability for a portion of the deficiency even if you knew or had reason to know of other understatements of tax on the return.

You make the election on Form 8857 (get it off your computer from or order it by phone at 1-800-TAX-FORM) and must apply within two years of when the IRS begins collection actions. There's a special election if you, at the time of the election, are no longer married to, are legally separated from, or have lived apart at all times for at least 12 months from your joint filer.

In any of those cases, you can elect to limit your liability to the portion of the deficiency that is attributable to items allocable to you. In simple terms, the IRS computes your returns as if you filed separately, then allocates your percentage of the total tax due on both returns to the actual deficiency. Assume the deficiency is $100 on a disallowed deduction. Had you filed separately, you would have had a total tax of $400 and your spouse a total tax of $600. The IRS can only go after you for 40% of what is owed, or $40.

If you and your spouse fraudulently transfer assets between you, though, neither spouse is eligible to make the election. If the IRS proves that the electing spouse had actual knowledge of the item on the return that is found to be incorrect, the election doesn't apply. However, the burden of proof here is on the IRS to establish actual knowledge.

Even if you don't qualify for innocent spouse relief or separation of liability, you may be eligible for "equitable" relief. To get this, it must be unfair to hold you liable for the underpayment or understatement of tax, taking into account all of the facts and circumstances.

If the IRS rejects your election as an innocent spouse, you can petition the Tax Court for judicial review. In that case, your spouse must be notified and has 60 days to intervene and contest your petition. After all, unless all parties are heard, we really don't know which is the "innocent" spouse.

Jeff A. Schnepper, Associate Economics Editor of USA Today, is an attorney and estate planner in Cherry Hill, N.J., and author of How to Pay Zero Taxes.
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Author:Schnepper, Jeff A.
Publication:USA Today (Magazine)
Article Type:Brief Article
Geographic Code:1USA
Date:Mar 1, 2002
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