INNOCENT SPOUSE PROTECTION FOR JOINT TAX FILINGS
In most settings, a married couple who file their income tax returns jointly will have less of a tax liability than if they file separately. However, the catch to filing joint income tax returns is that both spouses are liable to the government for additional taxes, penalties, and interest charges if one party fails to report an income source or the income source information reported is false.
Most people's tax filings are pretty straightforward, and the prospect of additional tax liabilities and penalties is unlikely. But there are occasions when a partner fails to include an income source or misrepresents their income from a business venture, and you get a notice from the IRS claiming money is due. After the panic subsides, the next question is whether you have any protection against the claims being advanced by the IRS.
The answer is that the Internal Revenue Code provides 3 separate avenues of relief to those “innocent” spouses who would otherwise be held liable for the tax errors/misrepresentations caused by their spouse in any jointly filed tax return.
Avenue #1 – General Relief under Section 6015(b) of Tax Code
An innocent spouse can be relieved of the joint and several liability imposed by a joint tax return if they make a timely request under section 6015(b) of the tax code, which establishes the following 4 requirements:
- The tax return in question must have been jointly filed;
- The understatement of tax must be attributable to an erroneous item provided by the other spouse (referred to as the “non-requesting spouse”);
- The innocent spouse (making the request for relief) did not have actual or constructive knowledge of the tax understatement made by the non-requesting spouse; and
- It is inequitable to hold the innocent spouse jointly and severally liable for the tax understatement made by the non-requesting spouse.
For most innocent spouses seeking relief under 6015(b), the constructive knowledge component of the 3rd requirement is the main hurdle to receiving the requested relief.
Not only does the innocent spouse have to prove to the taxing authority that they had no actual knowledge of the tax error but they must also prove that a reasonable person in their situation would not have been aware of the tax error either.
To determine whether constructive knowledge exists (i.e., whether a reasonable person in the innocent spouse’s shoes would have been aware of the tax error), they look at the innocent spouse’s level of education and level of involvement in the family finances, the non-requesting spouse’s level of evasiveness or deceit regarding the family finances, and the presence of unusual expenses compared to the family’s past level of income and expenditures.
The reason behind the constructive knowledge component of the 3rd requirement is to ensure that the 6015(b) protections are available only to the innocent, not the intentionally ignorant spouse.
If a spouse intentionally buries their head in the sand and knows or should know that the income information in the joint tax return is false, it is very difficult to obtain relief under this section of the tax code after the IRS discovers the tax error.
As a simple example, a husband owns and runs an ice cream shop, and he reports around 27,000.00 in income on their joint personal income tax returns each year after payment of expenses. Yet, from that ice cream shop, the parties live in a 750,000 home, both parties drive expensive cars, take 3-4 extended vacations per year, and have a 2nd home at the beach, worth about 600,000. If that 27,000 was their only income source, it is safe to say that the wife knew or should have known that the tax filings were probably false.
Avenue #2 – Proportional Relief under Section 6015(c)
Under this avenue of relief, an innocent spouse can seek to allocate the tax liability in a manner as if they filed separate returns. However, this avenue of relief is only available where the spouses are divorced or legally separated, and the innocent spouse did not have actual knowledge of the tax error contained in the jointly filed return.
Under section 6015(c) of the Internal Revenue Code, the IRS (not the innocent spouse) has the burden to prove that the innocent spouse was actually and clearly aware of the tax error. If the IRS cannot prove the innocent spouse had actual knowledge, then the proportional relief will likely be granted to the innocent spouse (assuming the other requirements are met).
It is important to keep in mind that, with this avenue of relief, the court does not make equitable considerations. Rather, the tax court focuses on the relationship between the spouses (or former spouses), whether they filed jointly for the return in question, and whether the IRS can prove that the innocent spouse had actual knowledge.
This is where parties to a divorce or separation setting should have a written indemnification agreement in place, whereby they agree to file jointly but each acknowledges that the neither party has personal knowledge as to the other party’s personal income setting for the joint filing.
Avenue #3 – Equitable Relief under Section 6015(f)
When the innocent spouse cannot get relief under section 6015(b) or (c), they can still turn to section 6015(f)’s equitable relief as the avenue of last resort.
Under this avenue of last resort, the innocent spouse must first satisfy the following 7 pre-requisites:
- The tax return at issue must have been filed jointly;
- The tax error must be (fully or partially) attributable to the non-requesting spouse;
- Relief cannot be available under sections 6015(b) or (c);
- There were no fraudulent transfers;
- The non-requesting spouse did not transfer disqualified assets;
- The innocent spouse did not knowingly participate in the filing of a fraudulent tax return;
- The innocent spouse files a timely claim for relief.
Assuming these 7 pre-requisites are met, the next step is to determine whether the innocent spouse is entitled to “streamlined relief.” To be entitled to streamlined relief, the innocent spouse must prove that they are no longer married; they would suffer economic hardship if the relief is not granted; and they lacked both actual and constructive knowledge of the tax error.
However, if the innocent spouse cannot establish their entitlement to streamlined relief (i.e., in the domestic violence setting where one spouse knows of the tax error but still signs the joint tax return out of fear of the other spouse), then the tax court must analyze the surrounding facts and circumstances to determine if the relief should be granted.
In performing this facts and circumstances analysis, the tax court looks at the following 7 factors laid out in Rev.Proc. 2013-34, section 4.03:
- Marital status;
- Economic hardship;
- Legal obligation to pay the tax liability;
- Amount of benefit derived from the tax error;
- Compliance with income tax laws;
- Mental and physical circumstances.
Although it is not common for a court to award a spouse relief where that spouse had knowledge (actual or constructive) of the tax error, courts are sensitive to situations where an innocent spouse cannot refuse (or doesn’t have the information to know they should refuse) to sign off on a joint tax return, especially in those settings where one spouse is abusive or financially controlling to the innocent spouse. In this limited setting, the tax courts have focused on all of the facts and circumstances surrounding the joint tax filing and even where the spouse had knowledge, it could still be available, but is an uphill battle to prove.
While the 3 avenues of relief set forth in section 6015 of the Internal Revenue Code have great advantages, these avenues of relief must be used with caution – especially for victims of domestic violence or those fearful of retaliation from the other spouse. Specifically, the non-requesting spouse is entitled to notice of the request for relief, has the ability to get copies of the application filed by the innocent spouse requesting relief, and has the right to intervene and participate in the related proceedings.