By Sidney Kess, Of Counsel, Kostelanetz & Fink, LLP and Robert S. Fink, partner, Kostelanetz & Fink, LLP
Married couples who file joint income tax returns are jointly and severally liable for the taxes, interest, and penalties (other than the fraud penalty) on those returns (Code Sec. 6013(d)(3)). However, one spouse may be relieved of liability under certain conditions. This relief is generally referred to as “innocent spouse relief.” This article details the conditions for relief, the types of relief available, and some important recent developments on innocent spouse relief.
Overview of Innocent Spouse Relief
Innocent spouse relief is a way for one spouse to avoid some or all of the liability for taxes on a joint return. The innocent spouse relief rules were first enacted in 1971. The initial rules, however, had thresholds for relief that many taxpayers were not able to pass. Over the years, various changes were made, and in 1998, the Internal Revenue Service Restructuring and Reform Act was enacted, which contains the liberalized rules in place today.
Discussed below are three distinct types of innocent spouse relief. Of course, different factual situations demand the application of different types of rules.
The taxpayer must file a timely request for innocent spouse relief. The IRS does not automatically provide relief; it must be requested on Form 8857, Request for Innocent Spouse Relief. This form is not filed with a tax return, but rather, directly with the IRS in Covington, KY, regardless of where a taxpayer has filed his or her tax return.
Types of Innocent Spouse Relief
Below you will find a discussion of the different types of innocent spouse relief:
Basic innocent spouse relief (Code Sec. 6015(b)). A spouse can obtain relief with respect to understated tax or erroneous items as long as you file the request form in a timely manner and send the form to the IRS in Covington, KY. If a spouse knew about some erroneous items but not others, partial relief is allowed. To make a claim for basic innocent spouse relief, all of the following conditions must be met:
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A taxpayer files a joint return which has an understatement of tax due to erroneous items of your spouse (or former spouse). Erroneous items include unreported income or incorrect deductions, credits, or tax basis.
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A taxpayer establishes that at the time the joint return was signed, he or she did not know, and had no reason to know, that there was an understatement of tax. The standard is whether a reasonable person under similar circumstances would have known about the understatement.
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Taking into account all the facts and circumstances, it would be unfair to hold the taxpayer liable for the understatement of tax. These facts and circumstances include a taxpayer’s educational background, business experience, and involvement in the business or transaction, which caused the understatement. The IRS will also look at whether the spouse claiming relief has received a significant benefit from the understatement.
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A request for relief must be filed within two years of when the IRS begins its collection activities.
A request for innocent spouse relief will not be granted if the IRS proves that the taxpayer and spouse (or former spouse) transferred property to one another as part of a fraudulent scheme. A fraudulent scheme includes a scheme to defraud the IRS or another third party (e.g., a creditor, ex-spouse, or business partner).
Separation of liability relief (Code Sec. 6015(c)). This second type of relief applies only to those who are divorced, legally separated, or have lived apart during the 12 months prior to filing this Form 8857. This relief limits the innocent spouse’s liability to the specific liability allocable to said spouse. Thus, if all of the liability on a joint return filed prior to a divorce (separation or living apart) relates to unreported income from the other spouse, then the requesting spouse is fully relieved of liability. However, no relief is granted if, at the time the tax return was signed, there was knowledge by the “innocent” spouse of any item resulting in an understatement; however, partial relief can be granted.
With separation of liability, unlike basic innocent spouse relief, the burden of proof for actual knowledge of the understatement of tax is shifted from the taxpayer to the IRS. Proof by the IRS that the spouse had reason to know of the understatement is insufficient to carry its burden. Moreover, even if the IRS proves actual knowledge, such knowledge is insufficient if the spouse proves that he or she signed the return under duress.
Equitable relief (Code Sec. 6015(f)). Even if a spouse does not meet all of the conditions discussed above, equitable relief can be granted if there is an understated tax or underpaid tax. Taking into account all of the facts and circumstances, it would be unfair to hold the spouse liable for the understated or underpaid tax. For example, if the “innocent” spouse signs an accurate return but payment is not made because the “guilty” spouse runs away with a lover and the family funds, the “innocent” spouse may be relieved of liability for the unpaid tax.
Relief arising from community property law. Spouses living in community property states may obtain relief from liability arising from community property law.
Recent Developments
Over the years, innocent spouse relief has been subject to considerable litigation. Here are some key issues that have been litigated recently.
Two-year limit. The Tax Code specifically states that there is a two-year period for making a claim for basic innocent spouse relief (Code Sec. 6015(b)(2)) or separation of liability relief (Code Sec. 6015(c)(2)). The Tax Code is silent with regard to equitable relief; however, there are regulations that extend the same two-year period to equitable relief (Reg. § 1.6015-5(b)(1)). In a case of first impression, the Tax Court ruled that the regulations adding the two-year period for equitable relief were invalid (Lantz, 132 TC 139 (2009)). However, the Seventh Circuit reversed that decision (607 F.3d 479 (7th Cir. 2010).
Recently, the Tax Court again had the opportunity to consider the issue and again said that the regulations were an invalid interpretation of the Tax Code (Hall, 135 TC No. 19 (2010). This case is currently on appeal in the Sixth Circuit.
Estate's payment of tax. In another recent case, a husband died and the estate paid the outstanding tax liability. The surviving spouse filed for innocent spouse relief, but the Tax Court denied her claim (Kaufman, TC Memo 2010-89). Since she was not the payor of the taxes, which were paid by the estate, she therefore could not recoup taxes from the government.
Impact of spousal abuse. In one recent case, a wife suffered verbal and physical abuse at the hands of her husband. She earned a small wage in one of the years in question (most of the income was the husband’s). Since she was able to prove the physical abuse that occurred throughout her marriage, the court said that it would be inequitable to hold her liable, even for the amount of tax attributable to her “small” earnings and granted her full relief.
Raising the issue of relief after court action. Can innocent spouse relief be claimed after a couple’s tax liability has been determined by the Tax Court? Apparently, the answer is “yes.”
In a recent case in which a wife and her husband litigated three consolidated cases for tax years 1996, 1997, and 1998 before the Tax Court (Diehl, 134 TC No. 7 (2010), the wife’s attorney raised the issue of relief from joint and several liability under Sec. 6015 in the petition for 1996, but not 1997 or 1998. The request did not specify any subsection of Sec. 6015. The wife then withdrew her claim for relief from joint and several liability in the stipulation of facts for the consolidated cases.
Her husband died after the opinion in the consolidated cases was filed, but before decisions were entered. After decisions were entered, the wife filed an administrative claim for innocent spouse relief for 1996, 1997, and 1998. The Tax Court said that the wife was not barred from electing relief under Sec. 6015(c), for 1996 and also relief under Secs. 6015(b), (c), and (f) for 1997 and 1998.
The IRS argued that res judicata (Code Sec. 6015(g)(2)) bars the wife from claiming relief from joint and several liability for 1996, 1997, and 1998, because the court had entered final decisions for those years. The wife said that res judicata was not an issue because the claim for innocent spouse relief had not been raised when the consolidated cases were decided.
The Tax Court disagreed with the IRS, holding that the wife did not participate in the litigation in a meaningful way, so she was not estopped from pursuing her claims for innocent spouse relief. Since the relief was not sought at the time those cases were considered, she was permitted to seek innocent spouse relief after the decisions had been entered.
IRS Publication 971, Innocent Spouse Relief (www.irs.gov). This publication, last revised in April 2008, contains the basic rules for claiming innocent spouse relief.
Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.
REVIEW QUESTION
True or False? There is a three-year period for claiming innocent spouse relief.
Answer: False
The Tax Code specifically states that there is a two-year period for making a claim for basic innocent spouse relief (Code Sec. 6015(b)(2)).
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