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Qualifying as the innocent spouse.

The IRS has the power to force certain taxpayers to pay tax deficiencies on income that is not theirs even if the taxpayers may know nothing about the deficiency. That is the situation many individuals find themselves in when the IRS forces them to pay tax on unreported and possibly illegal income of their former spouses. Quite possibly their only recourse is to rely upon "innocent spouse" rules.

To qualify for innocent spouse relief, the taxpayer must file a joint return. That return must have a substantial understatement of tax attributable to a grossly erroneous item of the spouse at fault. The taxpayer must show that in signing the return (s)he did not know and had no reason to know that there was an understatement. In addition, taking into account all facts and circumstances, the taxpayer must establish that it is inequitable to hold the taxpayer liable for the tax deficiency.


Congress enacted the "innocent spouse rule" in 1971 "to correct the unfairness in the situation brought to the attention of Congress and to bring government tax collection practices into accord with basic principles of equity and fairness."|1~ The restrictive rules provided by Congress showed their intent of providing relief only in particularly unfair cases such as a decision handed down by the Tax Court in Scudder v Comm'r. In that case, the husband did not disclose on the joint return income from embezzlements. The IRS forced the wife to pay the husband's taxes, interest and 50% of the fraud penalty despite the fact that she was unaware of the fraud and did not benefit from that income. Even worse, the wife was a victim of her husband's fraud because the wife and her sisters owned the business from which her husband was embezzling funds. The Tax Court acknowledged a problem in deciding against the wife and called for a legislative solution.|2~

Innocent Spouse Rules

Requirements to Qualify

Joint return test. Spouses who file a joint tax return are jointly and severally liable for the entire tax that is due. Even though a joint return is filed only one spouse may know about the accuracy of the return and whether the return is fraudulent. Under Section 6013(d) the innocent spouse rule can apply only if a joint return was filed for the tax year in question. Deciding if a spouse filed jointly is a question of fact and the intent of the spouse controls the outcome. In McRae, the wife seeking relief under the innocent spouse rule did not sign or even see the tax return in question but the court ruled she had filed a joint return because she knew that she had to file, her husband filed returns and she did not challenge the returns he filed.|3~ Substantiality test. An understatement of tax is the tax liability that is actually due less the amount of liability shown on the return. A $500 minimum is considered substantial (not including penalties and interest). Erroneous claims of deduction, credit or basis must also meet percentage-of-income requirements that are presumed to measure the innocent spouse's ability to pay. If the spouse's adjusted gross income (AGI) is $20,000 or less in the tax year prior to the deficiency notice, the liability (including penalties and interest) must be greater than 10% of AGI. If their income is greater than $20,000 in the tax year prior to the deficiency notice, the increased tax liability must exceed 25%. If the individual has remarried, the AGI of the new partner must be included in the spouse's AGI for the substantiality test for erroneous claims of deduction, credit or basis.|4~

Attribution test of grossly erroneous items. If seeking relief, the innocent party must show that the understatement of tax was attributable to the grossly erroneous claims of the spouse. They must also show not only ignorance of the understatement but that they had no reason to suspect an understatement.

With the exception of income from property, community property rules are not followed in determining to which spouse items of gross income are attributable. Relief to the innocent spouse is limited to items that are grossly erroneous. Any gross income attributed to the other spouse that is omitted from income is a grossly erroneous item. Items of deduction, credit or basis are considered grossly erroneous only if they are in an amount for which there is no basis in fact or law.

In effect, claims for relief involving items of deduction, credit or basis are limited to negligence or fraud.|5~ An overstatement of cost of goods sold that causes an understatement of income is considered an item omitted from income.|6~ A misclassification of income is not an omission of income.|7~ When a husband incorrectly classified income earned on an off-shore oil rig as foreign income exempt from U.S. taxation, the courts did not consider this an omission from income because the income was reported on a joint tax return. Since the claim of exempt income was not a claim of deduction, credit or basis, the misclassification was not a grossly erroneous item. The wife could not claim innocent spouse relief from tax due on the income earned on the offshore rig by the husband.|8~

No basis in fact or law. The Code does not define the phrase "no basis in fact or law." Congress gave a hint as to the phrase's meaning by using the example of "phony business deductions" as an example of an item without basis.|9~ What will and will not qualify has been left to the courts. A clerical error of claiming a $15,000 loss when the actual loss of $1,500 dollars had no basis in fact or law and was considered grossly erroneous.|10~ Without access to a partner's records, it is difficult for the spouse to prove the deductions are without basis in fact or law. Relief will be granted on deductions that were never paid but the mere disallowance of a deduction will not be considered grossly erroneous. A widow was denied relief when the husband did not leave any records that could support the claim that the disallowed deductions were without basis in fact or law.|11~ In LaMothe v Comm'r, relief was denied from a deceased husband's abusive tax shelters because 56% of the tax-shelter losses were allowed by an IRS appeals officer and 44% were denied. This compromise was used as evidence that there was at least some basis in fact and law.|12~ A totally disallowed deduction for a charitable contribution to the Church of Scientology was found to have some basis. The basis in law is that the charitable deduction was allowed in prior years until overturned by the Supreme Court. The basis in fact was that the taxpayer wrote out the checks at the direction of her husband.|13~

Lack of knowledge. Whether a spouse had reason to know about an understatement in tax liability is a primary consideration in determining innocence. As stated earlier, ignorance must be established of both an understatement and any possible reasons for suspecting an understatement of tax on the joint tax return that (s)he signed. This lack of knowledge must exist during the tax year in question and until the tax return is filed.

In one of the few cases where the husband filed for relief under the innocent spouse rule for alimony that was not included in income his wife received from a former husband, the Tax Court denied his claim because he knew about the alimony before the return was filed. There was conflicting evidence about whether the husband knew about the alimony during the tax year.|14~

In applying the standard for the knowledge test, the courts do not require that the spouse actually have knowledge of the understatement. The standard is whether a reasonably prudent person in a similar set of circumstances could see that there is a problem with the return. The burden of proof is on the spouse seeking relief to prove that (s)he did not have reason to know about an understatement of tax liability.

Factors in past cases that were used to determine a spouse's ability to know about a tax understatement include:

* whether the spouse's partner made lavish or unusual expenditures;

* the level of the spouse's involvement in family finances and budgeting;

* the level of the spouse's involvement in the family business;

* the spouse's level of education and amount of business background; and

* the extent to which the partner shared family financial information with the spouse.|15~

The courts seem to generally follow the reasoning that the person who is more educated and is involved in some way with business matters has more reason to know about an understatement of tax liability. Someone with no higher education or business experience is more likely to qualify as an innocent spouse. In Erdahl the wife sought innocent spouse relief and claimed that in signing the return she had no reason to know of an improper claim for partnership losses. She knew her husband had a partnership interest, that partnership transactions were intended to bring tax benefits, and that significant losses were claimed on the partnership return. The taxpayer, however, claimed that the circumstances that caused the disallowed loss arose from the operation of the partnership, of which she had no knowledge.

The Tax Court rejected this argument. The court added that the taxpayer should have inquired about large partnership losses because she knew the purpose of the partnership was to produce tax benefits and she could reasonably expect that there might be problems with the loss.|16~

Duty to inquire. At times the court will hold that the spouse has a duty to read the tax return before signing it and therefore could reasonably be expected to suspect an understatement of liability. In Cohen, a divorced schoolteacher and college graduate was not allowed to do an "ostrich imitation" and obtain relief by not reading the tax return. The liability under question was a tax shelter that even the husband, a CPA and partner with Peat Marwick, did not know was illegal.|17~

In Adams, the Tax Court ruled the taxpayer should have suspected that the spouse omitted income because she refused to be honest and open with him about the family income. Relief was denied because the taxpayer did not make a reasonable effort to determine the correct family income and he did not have access to the records of his spouse.|18~

Requirement of equitable treatment. An innocent spouse can obtain relief if in taking "all facts and circumstances" into account, it is inequitable to hold the innocent spouse liable for the tax understatement. One such factor is whether the spouse seeking relief was divorced, deserted or separated. The key factor in determining equitable treatment is the "all facts and circumstances" part of the code. Prior to enactment of this section of the law, the key factor was whether the taxpayer received significant benefit from the income that was not reported. In Cox v. Comm'r, the husband had no high school education, was borderline schizophrenic and had a long history of mental illness. The court decided it was inequitable to hold him liable for a tax understatement. His wife's purchase of inventory for a business he could not run was of no benefit to him. The cars and home improvements she bought with embezzled funds were soon confiscated and sold at auction, so they were a short-lived benefit.|19~

In Dakil, the courts decided not to hold the taxpayer liable because of her circumstances. The taxpayer was a widow receiving social security and working for nominal wages. The taxpayer's children were the beneficiaries of her husband's life insurance policies.|20~

Additionally, the Tax Court holds that it is not inequitable to hold a spouse liable for a tax deficiency due to omission of income if both husband and wife are ignorant of the omission. In this case, both spouses are "innocent" so there is no inequity in holding them both jointly and severally liable.|21~

Although "all facts and circumstances" as stated in Section 6013(e)(1)(D) is of prime consideration, "benefit to the taxpayer" under Regulation Section 1.6013-5(b) which was written under a previous law is still relevant because benefit to the taxpayer is still among the factors considered in equitable treatment. A taxpayer whose husband was a drug smuggler received only normal support from her husband and was separated from him for the tax year under question, so she did not benefit from his illegal income.|22~

In Hagaman, the taxpayer was estranged from her husband and did not know what type of activities he was involved in. The husband used the unreported income to maintain an adulterous relationship, which did not benefit the taxpayer. The taxpayer's standard of living was not enhanced by the unreported income for the tax years in question.|23~

In other cases, benefit to the taxpayer was a factor in denying innocent spouse treatment. In Wolfram, the taxpayer's husband embezzled funds from his employer. The taxpayer had to turn over assets to the court that she received as a result of unreported income. The court did not relieve the taxpayer because she previously enjoyed those assets and she had a lawsuit in the courts to retrieve the assets. If her lawsuit was successful, the court did not want this recovered wealth to go free of tax liability.|24~

In Hammond, the taxpayer lived in a luxurious house, kept harness racing horses, owned expensive cars, sent his children to private schools and generally lived in a manner far beyond what could be maintained on the income reported on the tax return. The taxpayer was denied relief.|25~

Tax Court's Narrow View of Innocent Spouse Rules

Belk v. Comm'r. In Belk, the husband of a taxpayer carried forward a long-term capital loss to 1976 when it should have been reported in 1974. The court held that there was no basis in law or fact for the loss. The court noted that if the loss was claimed as arising in 1976, the decision would be different for that loss because losses would not have been duplicated. The taxpayer's husband also claimed a short-term capital loss that should have been reported in earlier years. The Tax Court decided that this loss was not grossly erroneous because unlike the long-term capital loss carryovers, the short-term losses were claimed to have been incurred in 1976 when they were actually allowed in earlier years by agreement with the IRS.

The Belk case establishes very stringent guidelines for determining when an item is considered grossly erroneous. It follows from this decision that the mere claim of a deduction is enough basis in fact to disallow grossly erroneous treatment of an item if the deduction ever existed. The Eighth Circuit disagrees with the approach of the Tax Court in Belk. In the circuit court a taxpayer claimed a loss in the wrong year and the court found that there was no basis in the claim of loss during the wrong year. The claim was grossly erroneous.(26) The narrow view of the Tax Court is illustrated in another case, where an error in the cost of goods sold does not qualify for grossly erroneous treatment. The husband could not substantiate the cost of goods sold and the court held that the failure to substantiate the expense would not qualify for grossly erroneous treatment.(27)

Ness v. Comm'r. The problem with the Belk case is that it seems to establish that under certain circumstances no claim for deduction, credit or basis can be held as grossly erroneous. The Tax Court's view of what is grossly erroneous seemed to narrow even further in Ness.

The taxpayer's wife sought innocent spouse relief from her husband's disallowed losses from a limited partnership. The husband took losses for promissory notes for which he was not at risk. Section 465 requires that the taxpayer be at risk before this type of loss is claimed. There was clearly no basis in law for the deduction in view of Section 465. The Tax Court decided there was a basis in law because the IRS allowed a deduction for the amounts at risk. The court took the position that it could not allow part of the deduction to be grossly erroneous and part of it not grossly erroneous. The court was reluctant to apply different rules to the same transaction. The "in fact" basis does not hold up in Ness for the portion of the deduction not at risk because he never made the contribution for the amounts not at risk nor did he assume personal liability for the amounts at risk.

The opinions in Belk and Ness by the Tax Court seem to disallow any grossly erroneous claim in some circumstances regardless of well-settled legal principles as long as the taxpayer makes: a claim that he qualifies to claim the deduction.

The U.S. Court of Appeals at San Francisco heard the appeal of the Ness case. The court overturned the Tax Court's disallowance of the part of the partnership loss deduction for which the taxpayer was at risk. By taking this position the appellate court agreed with the wife that where part of the deduction was allowed, the portion disallowed was grossly erroneous because it lacked any basis in law.|28~

Rules Unfair to Poor Taxpayers

The arbitrary dollar limits on innocent spouse claims are biased against poor individuals and unfair to them. Amounts under $500 can be substantial to poor individuals and the amount can go well over $500 with interest and penalties included. The percentage income requirements covered earlier for a grossly erroneous claim of deduction, credit or basis limits qualification for relief as a substantial relief to very burdensome liabilities that might be beyond the innocent spouse's ability to pay. Additionally, requiring the innocent spouse to include his or her new partner's income in the percentage calculation to determine qualification as an innocent spouse even if (s)he files a separate return seems unjustified.

Proposals for change

Several changes to the rules could improve the fairness of the situation. The dollar limitations could be removed, as California did with its own version of innocent spouse rules. California has also repealed its own "no basis in fact or law" requirement so any disallowed claim of deduction, credit or item can possibly qualify for relief. There is no stated reason why simply non-payment of tax cannot qualify for relief. It seems that nonpayment of tax can be just as irresponsible as not reporting income and the consequences can be just as harsh to an innocent spouse. California provides relief for non-payment of tax if innocence can be proven and equity requirements satisfied.

A major improvement would be a requirement that the IRS first pursue the spouse whose income caused the deficiency and only then could the IRS pursue the other spouse. Such a rule would be similar to an amendment to Section 302(c), which allows a waiver of attribution to entities that have joint and several liability for income in the context of stock redemption. Congress intended that the tax should be collected from the entity that caused the deficiency before attempting to collect from the liable entity.|29~

Section 6013(d) requires that taxpayers who file a joint return are jointly and severally liable for that return. A more radical solution to the innocent spouse rules is to remove joint and several liability from joint returns. The IRS would then have to pursue the taxpayer who caused the deficiency on the joint tax return. Though many couples who file a joint return enjoy more favorable tax rates in filing a joint return, this was not the justification for requiring joint liability. Joint and several liability was required for joint returns in 1938, but benefits of income splitting were not introduced into the Code until 1948. Income splitting was not enacted as a reward for joint and several liability but to equalize the tax burden between common-law states and community property states. The benefits of filing jointly were not used as a justification for joint and several liability.|30~


The rule requiring joint and several liability for taxpayers who file a joint return is the basis that allows the IRS to pursue either the husband or wife for a tax deficiency. In many of these cases, the couple is separated or divorced and the IRS can pursue one individual even though the tax deficiency is caused by the other.

The most radical correction to this unfairness in the tax law is to repeal joint and several liability. Some of the moderate and more easily attainable improvements are to remove dollar limitations for seeking relief and remove the "no basis in fact or law" requirement for disallowed claims of deduction, credit or basis. Non-payment of tax can be added to the items eligible for relief and the IRS can be required to pursue the taxpayer whose income or deduction caused the tax deficiency before pursuing the other spouse. Until the rules are modified, taxpayers must qualify for innocent spouse status under restrictive rules and inconsistent court decisions.


1 H. Rep. No. 1734, 91st Cong., 2d Sess. 2 (1970)

2 Scudder v. Comm'r, 48 T.C. 36 (1967)

3 McRae v. Comm'r, T.C.M. 374 (1988)

4 Section 6013(e)

5 Section 6013(e)(2)(B)

6 LaBelle v. Comm'r, T.C.M. 602 (1986)

7 Sivils v. Comm'r, 86 T.C.M. 602 (1986)

8 Winnett v. Comm'r, 96 Y.C. 38 (1991)

9 H. Rep. No. 432, 98th Cong., 2d Sess., 2, at 1502 (1984)

10 Belk v. Comm'r, 93 T.C. 434 (1989)

11 Douglas v. Comm'r, 86 T.C. 758 (1986); Neary v. Comm'r, 50 T.C.M. 4 (1985)

12 LaMothe v. Comm'r, 58 T.C.M. 1358 (1990)

13 Foster v. Comm'r, T.C.M. 345 (1990)

14 Joss v. Comm'r, 56 T.C. 387 (1971)

15 Guthrie v. Comm'r, 897 F.2d 441 (9th Cir. 1990); Padgett v. Comm'r, 53 T.C.M. 332 (1987)

16 Erdahl v. Comm'r, T.C.M. 101 (1990)

17 Cohen v. Comm'r, 54 T.C.M. 537 (1987)

18 Adams v. Comm'r, 60 T.C. 300 (1973)

19 Cox v. Comm'r, T.C.M. 723 (1982)

20 Dakil v. Comm'r, 496 F.2d 431 (1974, CA10)

21 McCoy v. Comm'r, 57 T.C. 732 (1972)

22 Styron v. Comm'r, T.C.M. 25 (1987)

23 Hagaman v. Comm'r, T.C.M. 655 (1990)

24 Wolfram v. Comm'r, T.C.M. 422 (1987)

25 Hammond v. Comm'r, T.C.M. 22 (1990)

26 Belk v. Comm'r, 93 T.C. 433 (1989)

27 Portillo v. Comm'r, T.C.M. 68 (1990)

28 Ness v. Comm'r, 94 T.C. 47 (1990)

29 Joint Committee on Taxation, 97th Cong., 2d Sess. 146 (1982)

30 Revenue Act of 1948, Section 301

Ray A. Knight, JD, CPA, and Lee G. Knight, PhD, are professors of accounting and Philip K. Lee is a graduate student in accounting at Middle Tennessee State University in Murfreesboro.
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Author:Knight, Ray A.; Knight, Lee G.; Lee, Philip K.
Publication:The National Public Accountant
Date:Feb 1, 1994
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