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|JEFFREY J. BRYANT, CPA, JD, PhD, is associate professor of accounting at Wichita State University in Wichita, Kansas. His e-mail address is firstname.lastname@example.org . GARY M. FLEISCHMAN, CPA, PhD, CMA, is Holland Assistant Professor of Taxation at the University of Tennessee at Chattanooga. His e-mail address is Fleischman@utcdb01.utc.edu .|
any taxpayers don’t understand the profound consequences of signing their names to tax documents. Although signing a joint income tax return can lower a married couple’s tax obligation, joint and several liability can turn this advantage into a nightmare if one spouse omits income or claims fraudulent deductions. Joint and several liability obligates each spouse to individually pay the entire tax on a joint return. This means both spouses are fully responsible for the accuracy of a joint return, even if one spouse acts in bad faith.
IRS Publication 971, Innocent Spouse Relief, and Form 8857, Request for Innocent Spouse Relief, are available at www.irs.ustreas.gov .
After hearing testimony from witnesses who had suffered the consequences of their spouses’ tax excesses, Congress expanded the ability of taxpayers to claim the innocent spouse defense to avoid paying tax obligations their mates created. The Internal Revenue Service Restructuring and Reform Act of 1998 amended existing law, effective after July 22, 1998, so that aggrieved spouses now have three options:
- An augmented traditional innocent spouse defense against joint and several liability.
- A new separate liability election for recently divorced or separated taxpayers.
- Discretionary equitable relief from unpaid taxes reported on a return or any other tax deficiency.
The expanded legislation requires the IRS to establish procedures to alert taxpayers to the gravity of the joint and several liability their signatures impose. In response, the agency added an explanation of a spouse’s rights and responsibilities to IRS Publication 1, Your Rights as a Taxpayer, in a new section titled “innocent spouse relief.” The IRS is also required to alert married taxpayers to their individual liability for the total tax, interest and penalties on collection notices the agency sends to taxpayers. Congress also envisions that tax forms will clearly point taxpayers to statements explaining their liability.
While revised rules broaden the opportunity for innocent parties to avoid their spouses’ tax problems, they also complicate the job of CPAs who advise married clients. With the new law, nearly everyone who prepares joint income tax returns and advises married clients on tax matters must be aware of the innocent spouse defense options and understand their tax compliance implications.
THE REVISED TRADITIONAL DEFENSE
Congress repealed the requirements for establishing an innocent spouse defense and replaced them with more flexible rules designed to give taxpayers greater access to the defense. The new law relieves a taxpayer of liability for income tax to the extent he or she satisfies all of the following conditions:
- The liability arises from an understatement of tax on a joint return that is attributable to erroneous items reported by the other spouse.
- The taxpayer did not know or have reason to know of the understatement.
- Given all the facts and circumstances, it would be inequitable to hold the taxpayer liable for the tax deficiency.
- The taxpayer properly elects the innocent spouse defense.
As with prior law, an innocent spouse election is available only for understatements the IRS has already assessed, not for unpaid tax obligations shown on a filed return. The new rules apply to tax liabilities arising after July 22, 1998, and to liabilities that arose before this date but that remain unpaid.
The new rules are similar to the previous requirements concerning a spouse’s knowledge of a tax understatement and the equity of holding the spouse liable. However, Congress significantly changed provisions about how large a tax understatement must be and the guilt level of the noninnocent spouse. The new law also adds a requirement that a spouse elect the defense and for the first time authorizes the Tax Court to review the determination of a spouse’s innocence.
Magnitude of the understatement. Prior law required the noninnocent spouse’s understatement to be “substantial.” That is, it must have exceeded $500 before the defense was available. Further, a taxpayer could use the defense only for understatements of deductions or credits that exceeded a specified percentage of the innocent spouse’s adjusted gross income. For example, if a spouse wanting to claim the defense had AGI of $25,000 in the year before the IRS assessed the deficiency, then the tax understatement had to exceed 25% of AGI, or $6,250 in this example, before that spouse could get innocent spouse relief under prior law. The new law eliminates both of these dollar barriers to claiming the defense.
Guilt level of the understating spouse. The repealed provisions also required a higher degree of culpability from the guilty spouse before the other spouse could profess innocence. The understated item had to be “grossly” erroneous. Innocent spouses had to show the grossness of a tax return misstatement by demonstrating that the amount had no basis in fact or law. This compelled an innocent spouse to undertake the difficult task of proving the other spouse’s fraudulent or frivolous behavior. The new provision eliminates the need for a spouse to prove the degree of error by allowing relief for any “erroneous” item. However, the taxpayer still retains the burden of establishing that the erroneous item is attributable to the other spouse. Consequently, items derived from business or investment ventures both spouses own together rarely will be attributed solely to one spouse.
Knowledge requirement. Although Congress relaxed the requirements for an innocent spouse to claim the defense, that spouse still must prove that he or she did not know or have reason to know about the understatement. Presumably, the reasonably prudent person standard under former law still applies in determining whether a spouse had reason to know (constructive knowledge) of the understatement. Similarly, the factors the courts previously used to assess a spouse’s reasonableness in failing to know of an understatement are likely to remain relevant. These include the level of the innocent spouse’s involvement in family finances or the family business as well as the extent of his or her education and business background. The courts usually consider spouses with business backgrounds who are also very involved in family business matters to have constructive knowledge of a tax understatement.
Inequity of holding spouse liable. An innocent spouse still must demonstrate that circumstances exist that make it inequitable to hold him or her liable. The spouse carries the burden of establishing enough relevant facts to support his or her claim of innocence. As with the prior equity test, the extent to which a spouse benefited from any tax understatements likely will be a major consideration when the IRS decides whether the spouse deserves equitable relief.
The election. A new condition, which did not exist under the prior law, requires a taxpayer to elect the innocent spouse defense no later than two years after the IRS begins collection activities against that spouse. Previously, a taxpayer had no time limit in claiming the defense. A taxpayer must use Form 8857, Request for Innocent Spouse Relief, to make such an election. Although the law does not explain when IRS collection activities begin, congressional committee reports suggest lawmakers intended the two years to start when the IRS garnishes wages and mails levy notices against taxpayers’ property, not when it mails deficiency notices and demands for payment.
The revised innocent spouse law is much more flexible than its older counterpart. The exhibit below compares the old and new law for the traditional defense and summarizes the changes.
Jurisdiction to determine innocence. In addition to the formidable requirements of proof, prior law contained a procedural limitation that was frequently a significant obstacle to innocent spouse relief. Because IRS examination and deficiency notices often failed to reach both spouses when they no longer lived together, the 90-day period to petition the Tax Court usually expired before an unnotified spouse could react. His or her only remaining option was to pay the taxes, penalties and interest and file suit in a U.S. district court or in the Court of Federal Claims, raising the innocent spouse defense in a refund action. Unfortunately, many innocent spouses did not have the financial wherewithal to pursue that option. The new law expands the Tax Court’s jurisdiction to rule on the innocent spouse defense via IRC section 6015(e). A spouse need not pay the taxes before filing a Tax Court petition. He or she now may petition the Tax Court for relief during the 90-day period that begins when the IRS mails the taxpayer its rejection of that spouse’s asserted defense on form 8857. That form can be filed as late as two years after the IRS begins collection activities.
|Comparison of Old and New
“Traditional” Innocent Spouse Law |
THE SEPARATE LIABILITY ELECTION
Spouses filing a joint return have a completely new opportunity to avoid joint and several liability: the separate liability election of IRC section 6015(c). The advantage of this provision is that an electing spouse’s obligation for an IRS-determined tax deficiency will not exceed the obligation resulting from that spouse’s separate income and deductions. To elect separate liability, a former joint filer must be divorced, legally separated or living apart from his or her spouse during the 12 months preceding the election.
Allocation of separate tax liabilities is possible only for deficiencies arising from IRS examinations. The taxpayer cannot use the election to allocate responsibility for an unpaid tax reported on a filed return. Separate liability does not mean a spouse completely recomputes his or her separate taxable income and tax liability. For example, if a couple’s reported joint taxable income is taxed at a 39.6% marginal tax rate, each spouse will pay tax on his or her allocable share of any IRS-determined deficiency at 39.6%. This is the case even if one spouse’s separate contribution toward joint taxable income would have been subject to tax at only a 15% marginal rate. The time limit for filing a separate liability election is virtually the same as the two-year period for the traditional innocent spouse election.
Mechanics of a separate liability election. An electing spouse’s liability for a tax deficiency cannot exceed the portion of the deficiency allocable to that spouse. The deficiency is allocated between spouses—often using IRS-prescribed methods—in proportion to each one’s tax items, which the IRS took into account in determining the deficiency. The electing taxpayer assumes the burden of allocating responsibility between the spouses for the particular items of income, deduction or credit that caused the deficiency. Therefore, to use the election effectively, a spouse must have the records necessary to satisfy this burden. Without clear and convincing evidence to the contrary, business income and deductions, as well as tax items related to property, are allocated in proportion to ownership percentage. Subject to similar evidence, personal deductions are allocated equally between spouses.
Example. In 1999, Marci earned $30,000 from freelance work that she did not report. To make matters worse, she did not tell her husband Manchester about it. Further, Manchester claimed a $10,000 erroneous bad-debt deduction for a loan to his cousin. The IRS assessed a deficiency against the couple attributable to the $30,000 of unreported income and the $10,000 disallowed deduction. If Manchester elects separate liability, it would be limited to 25% of the deficiency ($10,000/$40,000); if Marci elects separate liability, it would be limited to the remaining 75%. If either Marci or Manchester does not elect separate liability, the nonelecting spouse is liable for the entire deficiency unless the revised traditional innocent spouse relief option (discussed earlier) or equitable relief option (discussed below) reduces it.
Innocence of the electing spouse. The separate liability election is a new option available only to a unique group of taxpayers. Two spouses who remain legally married or who have not lived apart for the requisite time are ineligible. On the other hand, there is no requirement that the spouse who elects separate liability has to be innocent. The election may be made by a spouse who benefited from an understatement or who is otherwise undeserving of equity. Specifically, a taxpayer may make a separate liability election without regard to whether he or she was previously denied traditional innocent spouse relief or concurrently filed an innocent spouse election. In other words, the separate liability election provides noninnocent, divorced taxpayers with an extra option to escape joint and several liability that innocent married spouses do not have.
While the congressional committee reports indicate the election is ineffective if the electing taxpayer has actual knowledge of an incorrect item on a joint return, the IRS must establish this to be the case. Actual knowledge will not be inferred just because the electing spouse should have known or had reason to know of the tax item. A tax understatement the electing spouse has knowledge of will be allocated to both spouses who filed the return.
Practically speaking, even a spouse with actual knowledge of the understatement may receive a favorable resolution because the IRS shoulders the burden of proving the taxpayer had such knowledge. Further, the IRS may have to prove particular knowledge of each underlying transaction, along with knowledge of the tax treatment for each item, not merely general knowledge of an understatement. While such a burden is nearly insurmountable, the IRS likely can count on assistance from the other spouse to make its case. Clearly, however, a spouse without actual knowledge who nevertheless should have known about the understatement is entitled to separate liability relief.
Effects of a separate liability election. Since the law makes a separate liability election available to virtually all divorced taxpayers, two situations may cause problems.
- The potential exists that ex-spouses who are willing to collude in their divorce agreement negotiations to minimize tax collections could abuse this election. For example, the spouses may agree to allocate a deficiency to a judgment-proof spouse. Congress expressly indicated that the IRS’s inability to collect a deficiency from the spouse it was allocated to does not permit the agency to collect from the other spouse.
To combat abuse, the IRS can invalidate an election when it shows that assets were transferred between spouses in a fraudulent scheme. Further, the IRS will increase an electing spouse’s liability by the value of any “disqualified asset” transferred from one spouse to an electing spouse for purposes of avoiding the payment of tax.
- At the other extreme, noninnocent warring ex-spouses can use the election as a weapon against one another. As a result, both spouses probably should file separate liability elections automatically after a divorce. Without the election, a spouse will remain liable for the entire deficiency under joint and several liability while the IRS is limited to collecting only the separate liability from an electing ex-spouse. Both spouses will want to defend their proposed allocations and have it make a difference to their tax liabilities. This creates a potential dilemma for CPAs involved with preparing the joint returns of divorcing or separating spouses. The law puts them in an unenviable position, similar to attorneys representing both sides in a divorce.
Advising clients. When clients divorce, CPAs should immediately obtain a separate liability election from both spouses. Preparers should require each ex-spouse to direct the CPA to file an election or explicitly decline to exercise that option, in writing. CPA firms should establish a consistent policy of recommending the election to both ex-spouses. Suggesting one spouse follow a particular course of action based on knowledge of the alternative the other spouse has chosen may cause a CPA to violate the AICPA Code of Professional Conduct. Generally it is not advisable for a CPA to keep both former spouses as clients. If both ex-spouses are to remain clients, however, CPAs should obtain informed consent from each indicating he or she understands the other spouse is also a client.
Jurisdiction to determine a spouse’s separate liability. As with the innocent spouse election, Congress granted the Tax Court new jurisdiction to rule on separate liability elections after a deficiency assessment. The filing deadline is the same for both elections. Since the separate liability election cannot create a refund for an electing spouse, the Tax Court does not have authority to order a credit or refund to a separate liability petitioner.
When a taxpayer does not qualify for traditional innocent spouse relief, is not eligible for a separate liability determination or seeks relief that is not available under either of these two provisions, his or her last resort is to rely on the mercy of the IRS. Congress created new relief from both unpaid taxes and deficiencies via IRC section 6015(f) for spouses who, based on the facts and circumstances, should not equitably be held liable. To qualify for equitable relief, a taxpayer cannot meet the requirements for either of the other two options.
Equitable considerations. Congress intends equitable relief for taxpayers who do not know or do not have reason to know that their spouse misused funds intended to pay a reported tax. Thus, equitable relief permits innocent spouses to escape liability for taxes shown on a signed, filed tax return, not just for subsequently determined deficiencies. The IRS has indicated it ordinarily will grant relief from unpaid liabilities if the taxpayer is no longer married to the joint filer, has experienced abuse, has not significantly benefited from the unpaid liability and will suffer undue hardship without equitable relief.
However, Congress also intended that the IRS exercise discretion for relief in other circumstances as well. Of the factors the IRS will use to determine a taxpayer’s qualification for relief, perhaps the most important is whether a taxpayer had reason to know of the unpaid liability or deficiency. Another factor is which spouse has the legal obligation to pay the liability under a divorce decree. Consequently, how a couple’s divorce decree addresses liability for taxes may have a major impact on the availability of equitable relief.
Jurisdiction to grant relief. Equitable relief is the one joint and several liability relief provision over which Congress did not expressly extend the Tax Court’s jurisdiction. As a result, the IRS has asserted that the Tax Court cannot review any denial of equitable relief. Apparently, taxpayers cannot appeal the IRS’s subjective judgment in equitable relief cases.
IN THE CLIENT’S INTEREST
The expanded law relaxes the conditions a taxpayer must meet to claim the traditional innocent spouse defense while also adding two other options. CPAs must understand all three options to properly serve their clients. These provisions undoubtedly will provide additional avenues for innocent spouses to use to escape the haunting burden of joint and several tax liability.