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New developments in innocent spouse rules.

ABSTRACT

Both spouses are usually liable for taxes owed to the IRS on a joint tax return. However, the "innocent spouse doctrine" offers relief to a spouse when it would be inequitable to hold that spouse liable for taxes created by the other spouse. The innocent spouse laws have gone through numerous changes over the years and Congress made a major revision to the law in 1998. The revised law has made it easier to obtain innocent spouse relief when inequitable situations arise. This article traces the development of the innocent spouse provisions in the literature with emphasis on the legislative history. The article then explains the current innocent spouse rules and discusses the implications of Code Section 6015. Finally, the article summarizes new developments in the innocent spouse provisions with particular emphasis on a recent Tax Court decision in 2006 that deals with innocent spouse rules in community property states.

INTRODUCTION

An innocent spouse is someone who has filed a joint return with his or her spouse and is being held accountable for a tax liability because of an erroneous tax return filed by the other spouse. The innocent spouse must prove that he or she had no knowledge of the error or omission and that it would be unfair to hold him or her accountable for the tax liability, penalties and interest. There are three different types relief available for these types of situations. These are innocent spouse relief, relief by separation of liabilities, and equitable relief. The type of relief available to an individual varies depending on various factors and circumstances, such as tax filing status, marital status and community property laws. This paper provides a review of the legislative history of the law, discusses the innocent spouse provisions, and looks at recent developments in the law.

LEGISLATIVE HISTORY OF JOINT AND SEPARATE RETURNS

Prior to 1918, joint returns were not allowed and each spouse was required to file his and her return separately. The Revenue Act of 1918 enacted provisions that permitted married couples to file joint tax returns. The law was unclear as to whether married couples could still file separately until Congress passed the Revenue Act of 1921. This Act clarified that a husband and wife may either file separate returns or a joint return. Initially, the IRS took the position that when a joint return is filed, both husband and wife have joint and several liability for the entire tax due on the return. The IRS viewed the joint return as pertaining to one taxable unit and thus both were responsible for the entire amount of the tax liability.

Many taxpayers disagreed with this approach and in 1935 a case involving the issue of joint and separate liability of tax was heard by the Ninth Circuit Court of Appeals. The case of Cole v. Commissioner centered on an attempt by the IRS to collect a joint return liability from the estate of a wife. The IRS argued that because a joint return does not segregate the respective income and expenses of each spouse, it is impossible to determine the respective tax liabilities of the individual spouses. The IRS also argued that joint and several liability is the price that a married couple pays for the privilege of filing a joint return. The Ninth Circuit Court of Appeals rejected these arguments for joint and several liability and ruled that it is possible to separate the tax liability of the respective spouses.

Disputes between the IRS and taxpayers continued due to the ambiguity of the issue and Congress attempted to clarify the issue further with passage of the Revenue Act of 1938. That Act clearly established the principle of joint and several liability on a joint tax return. This provision is still in place and is found in Code section 6013(d).

Prior to 1948, married couples filing jointly used the same income tax computation schedule as couples filing separately. This tax structure created an incentive for couples to file separately because with a progressive income tax, a married couple could often reduce their combined tax liability by filing separately. This enabled couples to split their total income between the two spouses and thus lower their tax rates. The Revenue Act of 1948 created a separate tax schedule for a joint return filing status. This new schedule introduced a marriage bonus into the tax law and since that time most married couples file jointly.

HISTORICAL BACKGROUND OF THE "INNOCENT SPOUSE" PROVISIONS

Over the next few decades, it became apparent that the joint and several liability doctrine imposed an unfair burden on many taxpayers who filed joint returns. There were cases where a joint return was filed and one spouse was guilty of grossly understating income and thus the tax liability. The other spouse often had no knowledge of the intentional erroneous filing. Congress was concerned about the injustice imposed by joint and several liability in such cases. To address this problem, Congress amended the code and enacted IRC Sec. 6013(e) in 1971.

This provision provided relief from joint and several liability for "innocent spouses" in certain limited circumstances. The provision set forth three tests for determining whether innocent spouse relief should be available: (1) the income omitted had to exceed 25 percent of the gross income reported on the return, 2) the innocent spouse must prove that he or she did not know of the omission from income and, (3) the innocent spouse did not benefit from the items omitted from gross income. The provision focused on providing relief for an innocent spouse when income was understated. It did not address situations where deductions and tax credits were taken to which the taxpayer was not entitled. In addition, many high-income couples fell short of the requirement that the omission must exceed 25% of gross income.

Congress significantly altered the structure of the innocent spouse rules with the Deficit Reduction Act of 1984. Congress amended Sec. 6013(e) to alleviate what it perceived to be inequities in the law. One common situation, which often occurred, involved a spouse overstating business deductions in order to avoid paying tax while the other spouse was unaware that the deductions were erroneous. The Deficit Reduction Act of 1984 liberalized the circumstances under which innocent spouse relief can be granted by extending that relief to situations in which a substantial understatement of tax was attributable to claims of deductions, credits, and bases for which there is "no basis in fact or law". The revised statute removed the requirement that the innocent spouse must show that he or she did not benefit from the effects of the grossly erroneous items.

The act also changed the substantial understatement threshold. It established $500 as the amount of substantial understatement required before relief can be granted. In addition, the tax liability had to exceed a certain percentage of the innocent spouse's gross income. If the innocent spouse's adjusted gross income was $20,000 or less, relief would only be granted if the understatement exceeded 10% of the adjusted gross income. This change made it easier for an innocent spouse to obtain relief if the other spouse's income was relatively high. The Act also expanded the innocent spouse provisions to include tax relief due to improper deductions as well as unreported income. Congress was concerned about situations where one spouse claimed improper deductions in order to avoid paying tax and the other spouse did not know that the deductions were improper.

THE IRS RESTRUCTURING AND REFORM ACT OF 1998

The number of innocent spouse claims continued to increase and Congress once again responded. As part of the IRS Restructuring and Reform Act of 1998, the requirements for obtaining innocent spouse relief were relaxed. The prior rule that an understatement had to be "substantial" was changed so that all tax understatements qualified for innocent spouse relief. In addition, the prior rule that omitted income items had to be "grossly erroneous" was changed so that they only had to be "erroneous". The easing of the restrictions on innocent spouse relief made the determination of eligibility for relief simpler. The basic provisions of the 1998 Act are still in place.

CURRENT INNOCENT SPOUSE RELIEF PROVISIONS

In order to qualify for traditional innocent spouse relief there are currently five requirements that must be met. These requirements are: (1) spouses have filed a joint return for a taxable year, (2) there is an understatement of tax on the return due to erroneous items of one of the spouses filing the return (3) the innocent spouse establishes that when signing the return he/she did not know of the understatement (4) it is inequitable to hold the innocent spouse liable for the deficiency in tax because of the understatement, and (5) within 2 years of when the IRS begins collection activities, the innocent spouse must properly elect relief.

One of the main determinations that the IRS must take into account when determining the facts and circumstances of a case is whether or not it would be unfair to hold the innocent spouse responsible for the understated tax, penalties, and interest of their spouse. IRS Publication 971 gives several examples of factors that the IRS will take into consideration in determining unfairness. One of these is whether or not the innocent spouse received a "significant benefit" from the understatement of tax. By taking into consideration the facts and circumstances involved in an innocent spouse case, the IRS can best determine whether an individual knew or had reason to know of an understatement, and whether or not it would be fair to hold the innocent spouse liable.

An example of an understatement of tax in an innocent spouse situation is the case of Linda Evans and Estate of Robert C. Evans, Jr., Deceased, Linda Evans, Executrix v. Commissioner. In this case the petitioner, Ms. Linda Evans, argued that she was an innocent spouse and should not be held liable for over $55,000 in understated taxes and penalties due to improper deductions and unreported income from 1989 to 1991. Ms. Evans and the late Mr. Robert C. Evans Jr. received royalties from an oil and gas company and deducted certain amounts of these royalties because he said they were reported as income on an estate in bankruptcy return. The trustee of the estate never received any royalties or reported any income from them on the estate's tax returns. Mr. Evans also ran, as a sole proprietor, a ranching business that Ms. Evans had knowledge of. In 1989, Mr. Evans sold some of the cattle from his ranching business for $60,247 and recorded the transaction in the business sales journal, which neither he nor the trustee of the estate reported for federal income tax purposes. All of the tax returns in question were prepared by an accountant and signed by Ms. Evans without her reviewing or questioning them. Ms. Evans knew where all of the personal and business financial records were kept and had access to them.

The court ruled that Mr. and Ms. Evans were not entitled to the deductions they took because they failed to prove that they did not own or receive the royalties that they claimed were a loan from the trustee of the estate. The court also ruled that Mr. and Ms. Evans were responsible for the income from the sale of cattle that they failed to report in 1989 since they failed to prove that the cattle was sold by secured creditors of Mr. Evans.

Ms. Evans claimed that she was an innocent spouse and should not be held liable for the additional tax and penalties. She did not review the returns because she assumed that, since the accountant prepared them, that they were prepared correctly. Ms. Evans also maintained that even if she had reviewed the returns she would not have understood them without the assistance of an advisor. Ms. Evans also requested that the non-qualifying deductions be considered unreported income. The court refused to consider the deductions as an unreported income issue since Ms. Evans and her late husband included the income on their 1040 for the years in question and took deductions on this income. The court also did not agree with Ms. Evans that she had no knowledge or reason to know of the understatement of income due to the 1989 sale of cattle. The court ruled that Ms. Evans did not meet the requirement for innocent spouse relief because she had knowledge of her husband's business activities and the couple's finances. The court also pointed out that even if she did not know of the understatement of income, she took no steps to determine the accuracy of the return, which a reasonable person in this position would have done. The court stated that Ms. Evans could have easily discussed the returns with her late husband before signing the returns. The court held that Ms. Evans was not an innocent spouse in any of the years in question.

RELIEF BY SEPARATION OF LIABILITY

If individuals do not meet all the requirements for traditional innocent spouse relief, a second source of relief is available, which is relief by separation of liability. In order to be eligible to make the election for separation of liability under IRS Code Sec. 6015(c) one of the following two conditions must be met: (1) at the time of election, the individual filing the election is no longer married to, or is legally separated from the individual with whom the joint return was filed, or (2) the individual was not a member of the same household as the individual with whom the joint return was filed during the 12-month period ending when the election was filed.

Relief by separation of liability will not be granted if the IRS shows proof that the property was transferred as part of a "fraudulent scheme." Additionally it will not be granted if the IRS can prove the spouse filing the claim had actual knowledge of the "erroneous items." Finally, it will not be granted if the property was transferred from one spouse to the other for the purpose of avoiding tax or reducing the tax liability. Relief will only be granted if the spouse filing the claim did not have actual knowledge of the erroneous items. The IRS does not have to prove that the spouse knew how the income was originated. It only has to prove that the spouse knew of the existence of the income. Additionally the spouse cannot use the defense of not having actual knowledge of the items if the basis of that defense is that they did not know how to report the item on the jointly-filed tax return.

An example of separation of liability can be seen in Joan Phyllis Levy v. Commissioner, This case dealt with tax deficiencies for several years and ruled that for the 1979 tax return, Mrs. Levy did not qualify as an innocent spouse under IRC section 6015(b), because she was unable to prove that a reasonable person would not be expected to know there was a tax deficiency. However, the court overruled the IRS and granted separation of liability under section 6015(c). Section 6015(c) applies when the income which accounts for the tax liability would have been properly allocated to the other spouse if they had filed separate tax returns instead of a joint tax return.

During Dr. And Mrs. Levy's marriage, Mrs. Levy was a full-time homemaker and although she knew that her husband did practice medicine, she was not involved with any of the financial dealings of the household. All household bills where paid by her husband, and furthermore, she did not have access to the checking account where her husband deposited the money. She was provided cash by her husband as needed for expenses and did not live a lifestyle that was unreasonable in light of the amount expected by the income reported on their tax returns. The family took no expensive vacations and she did not furnish their house with expensive items. Additionally, she did not have a credit card until 1999. After separating from her husband in 1994, he still paid the household bills for the condominium that she resided in and provided cash or a check for living expenses that she deposited into her own checking account.

The court pointed out that Dr. Levy testified that he invested in a tax shelter and that Mrs. Levy did not participate or have knowledge of the tax shelter. The record also showed that she did not participate in his medical practice and barely had any knowledge of his financial transactions. Even though Ms. Levy did not qualify as an innocent spouse, she qualified for relief under the separation of liability rules. Additionally, with separation of liability, unlike innocent spouse, the burden of proof for actual knowledge is shifted from the taxpayer to the Internal Revenue Service. This case illustrates the difference that can result between asserting the doctrine of innocent spouse versus that of separation of liability.

EQUITABLE RELIEF

An innocent spouse may also qualify for relief under the equitable relief provisions. Under this type of relief, one may request to be relieved of the responsibility of tax, interest, and penalties. This relief applies to any tax liability arising after July 22, 1998 and any tax liability arising on or before the date but remaining unpaid as of that date. Equitable relief differs from innocent spouse relief and separation of liability because it allows an individual relief from an understatement of tax or an underpayment of tax. An underpayment of tax by definition "is an amount of tax one properly reported on a tax return but has not paid." If the taxpayer satisfies the required conditions for equitable relief, then the IRS is obligated to evaluate the positive and negative factors to determine whether full or partial relief should be granted the taxpayer.

An equitable relief ruling can be seen in the continuation of the case of Joan Phyllis Levy v. Commissioner. As stated previously, this case dealt with extensive tax liabilities that included the tax returns for 1979 and 1991 through 1999. The court ruled in favor of Mrs. Levy and granted separation of liability for the tax year 1979, but did not grant separation of liability for years 1991 through 1999. The court justified this decision by pointing out that the agreement was reached through both parties' attorneys and Mrs. Levy had no reason to know at that time that Dr. Levy planned to file bankruptcy to avoid payment of the taxes.

The court determined that the divorce settlement entered into in August 2002 put all legal responsibility on Dr. Levy to pay the unpaid taxes for years 1991-1999. In determining if she qualified under the economic hardship factor, the court ruled that she did not qualify because her children were no longer dependents. She was also entitled to $4,400 per month in alimony payments from Dr. Levy. Additionally she owned the condominium which was valued at $350,000, and only had a $60,000 mortgage against it. The court ruled that she was not at or near the poverty level and would not suffer economic hardship upon paying the tax liabilities.

Regarding the question of whether Mrs. Levy had knowledge or reason to know that the tax liability would not be paid by Dr. Levy, the court reached a split decision for the years 1991 through 1999. The court determined that for the tax years between 1991 though 1995, Mrs. Levy had no knowledge or reason to know that Dr. Levy would not pay the tax liability. But the court determined that on May 22, 1997, Mrs. Levy signed a tax waiver for the unpaid taxes from 1979. Therefore the court determined that she had reason to doubt if Dr. Levy would pay the tax liability for all tax years following that time.

In considering whether Mrs. Levy received significant benefit from the unpaid tax liabilities, the court ruled that living expenses do not qualify as a significant benefit. However, the college tuition paid by Dr. Levy for the education of their three children did qualify. The final ruling of the court granted separation of liability for the 1979 tax year, and granted equitable relief for the tax liability for years 1991 through 1995. For the tax years 1996 through 1999, the court ruled that Mrs. Levy did not qualify for any relief under Sec 6015.

COMMUNITY PROPERTY

Community property laws can have an impact in determining if a taxpayer is able to qualify for innocent spouse relief and what type of relief may be available. Community property is defined as property:

(1) That you and/or your spouse acquired during marriage while living in a community property state.

(2) That was converted to community property, from separate property, by agreement by the taxpayer and their spouse.

(3) That can't be identified as separate property.

A taxpayer may have community property if the taxpayer is married and has lived in a community property state during the tax year. The idea of community property is tied to the taxpayer's permanent home. For instance, if a taxpayer is living, working, and earning a living in a non-community property state but their permanent home is in a community property state, then all income earned is considered community property.

There are special circumstances that allow a taxpayer to report community property income separately. Income can be reported separately by the spouse that earned the income if the couple (1) lived apart the whole year, (2) did not file a joint return, and (3) had earned income that is community property and did not transfer any of the income between themselves before year end. One of the most recent rulings involving the community property laws and the innocent spouse rules was the case of Lois E. Ordlock v. Commissioner, which was decided in January 19, 2006. In that case, a taxpayer's husband underreported the couple's income and understated the couple's tax liabilities. The spouse was granted innocent spouse relief and relieved of the husband's tax liability. In subsequent years, the husband continued to underreport income and taxes. The husband paid the IRS those assessments from community property.

The innocent spouse in the case filed for a refund of that portion of the tax that was paid from community property income. Her reasoning was that she was innocent of the tax liability. She further reasoned that the payments made by the husband were from community property and consequently her share of the community property that was used to pay the taxes should be refunded. The court ruled that the innocent spouse was not entitled to a refund. It pointed out that this precedent could lead to extremely complex problems of sorting out what part of the payments are would be considered community property. In addition, an innocent spouse could pay all of the tax liability and then file a claim for a refund by claiming the payment was community property.

CONCLUSION

The innocent spouse provisions are a significant topic in tax law due to the number of taxpayers affected and the principle that the tax laws should be applied in an equitable manner. Understanding the application of the rules is extremely important since many unsuspecting spouses have been left with large assessments because of erroneous actions of the other spouse. The determination of relief under Section 6015 consists of an extensive process of investigation required by both the filing spouse and the IRS to provide proof of whether the spouse qualifies for relief. The granting of relief is possible under three different situations and it important that taxpayers and practitioners understand the options available. Community property laws also affect the innocent spouse rules. Tax practitioners who are knowledgeable in this area of the tax law should be able to maximize tax savings for clients under the innocent spouse rules.

REFERENCES

Deficit Reduction Act of 1984, 98-270, Pub. L. No. 98-369.

Frida Hellman Cole v. Commissioner, 1935, 8i F.(2d) 485, 487 C. C. A. 9th.

Internal Revenue Code of 1986, Code Section 6013, 6015.

Internal Revenue Service Publication 971, "Innocent Spouse Relief," April, 1998.

IRS Restructuring and Reform Act of 1998, Section 6013(e), HR 2676.

Joan Phyllis Levy v. Commissioner, April 26, 2005, TCM, 004(m).

Linda Evans and Estate of Robert C. Evans, Jr., Deceased, Linda Evans, Executrix v. Commissioner, January 12, 1998, TCM 52,513(m).

Lois E. Ordlock v. Commissioner, January 19, 2006, 126 TCM, 17021-02.

Revenue Act of 1918, 40 Stat. 1057.

Revenue Act of 1921 (ch. 234, 43 Stat. 253.

Revenue Act of 1948, 62 Stat. 110.

John Leavins, University of St. Thomas

Darshan Wadhwa, University of Houston-Downtown

Charles Smith, University of Houston-Downtown
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Author:Leavins, John; Wadhwa, Darshan; Smith, Charles
Publication:Academy of Accounting and Financial Studies Journal
Geographic Code:1USA
Date:Jan 1, 2008
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