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Domestic Relations Provisions of the IRS Restructuring and Reform Act of 1998

Family Law

The IRS Restructuring and Reform Act of 1998 (RARA), signed by President Clinton on July 22, 1998, contains important new provisions dealing with taxpayer’s rights and also provisions that correct or modify The Taxpayer Relief Act of 1997. This article will summarize the new domestic relations provisions.

Joint and Several Liability

IRC §6013(d)(3) provides: “If a joint return is made, the tax shall be computed on the aggregate income and the liability with respect to the tax shall be joint and several.” Before the changes discussed below, each spouse was potentially liable for the full amount of the tax or any deficiency in tax, penalties, or interest; and one spouse could not insist that the IRS first collect the tax or deficiency against the other. The only theoretical escape hatch from joint and several liability was contained in IRC §6013(e), the so-called “innocent spouse” provision. To qualify the innocent spouse had to prove that he or she had filed a joint return in which there was a substantial understatement of tax attributable to grossly erroneous items of the other spouse about which he or she did not know and had no reason to know and that, under all of the facts and circumstances, it would be inequitable to hold the innocent spouse liable for the tax. There were dollar limitations and percentage of income tests for the terms “substantial understatement” and “grossly erroneous items” which had to have “no basis in law or fact.”1 The bottom line was that courts rarely found one to qualify as an innocent spouse. Thus, in practice, there was no relief from joint and several liability.

Election to Limit Liability. New IRC §6015(c) establishes an election which, if properly effectuated, limits one spouse’s income or self-employment tax liability to that portion of the tax deficiency attributable to his or her own erroneous items on a joint return and excludes those attributable to his or her spouse. The election applies to tax liabilities arising after the date of enactment (July 22, 1998) as well as to any liability arising on or before the date of enactment that remains unpaid on the date of enactment. The two-year election period will not expire before two years after the first qualifying collection activity taken by the IRS after the date of enactment.2 The items allocated to a spouse are those that would have been allocated to that spouse on a married filing separate return.

Eligibility to Make the Election. Marital status is the linchpin. The election is available to one who has filed a joint return and, at the time the election is filed, with regard to the other spouse, is either: 1) no longer married; 2) legally separated; or 3) was not a member of the same household with the other spouse at any time during the 12-month period immediately preceding the election.

Time for Making Election. The election must be made not later than two years after commencement of IRS collection activity against the spouse seeking to make the election ( e.g., garnishment of wages or notice of intention to levy directed against the electing spouse; but, not mailing of notice of deficiency, addressed to both spouses, to last known address of electing spouse).3

How Election Made. The IRS is to create a form for making the election within 180 days from the date of enactment. The author suggests that, in the meanwhile, taxpayers file a separate statement titled, “Election under IRS §6015(c).” The statement should recite that the executing spouse is electing separate liability under §6015(c), as amended by RARA, and the factual basis giving rise to that spouse’s eligibility, i.e., divorced, legally separated, or living apart for the 12 months immediately preceding the election. The properly completed statement should be filed with the IRS district office in which the spouse resides and with the IRS service center in which the spouse’s Form 1040 is filed.

Fraudulent Transfers of Property Between Spouses. If proven by the IRS, the election is invalid as to both spouses.

Spouse with Actual Knowledge. Even though not allocable to a spouse, he or she shall be charged with the tax liability for any item about which he or she had actual knowledge unless the return in question was signed under duress. The IRS has the burden of proving actual knowledge.

Increase in Liability of Spouse to Whom Asset Transferred for Tax Avoidance. The value of these disqualified assets increases the portion of the tax liability for which the transferee spouse may be liable. For this purpose there is a one-year look-back period from the date of the 30-day letter ( i.e., notice of proposed audit adjustments advising one of right to administrative review before the IRS appeals division).

Divorce and Other Transfers Not Disqualified. Assets not treated as disqualified are those 1) transferred pursuant to decree of divorce or separate maintenance or written instrument incident to such decree; or 2) any transfer which an individual establishes was not for the principal purpose of tax avoidance.

Allocation of Items. Generally, items are allocated to the spouse who is the source of an item. Specific examples in the committee reports are: 1) wages to the spouse working on the job and receiving the Form W-2; 2) net business and investment income (including capital gains) in proportion of title ownership in the absence of clear and convincing evidence supporting a different allocation; 3) personal deductions allocated equally unless shown to be paid from one party’s separate assets, e.g., donation of overvalued painting owned separately by husband gives rise to deficiency and penalty which would be allocated to husband, if facts proven by wife; 4) deductions allocated only to extent of tax benefit; the excess, if any, allocated to other spouse if tax benefit derived by that spouse; 5) losses allocated to the asset owner spouse up to income offset thereby; remainder of loss allocated to other spouse; 6) income tax withholding allocated to spouse from whose paycheck it was withheld; 7) estimated tax payments allocated to spouse who paid. Allocated equally, if payments made jointly. What if payment made by one spouse from joint funds transferred into separate account? The author believes that the payment would be treated as a joint payment if the facts are proven.4

Examples of Allocations. The committee reports offer some examples. Assume in each example that H & W are no longer married but had joined in a joint return during the marriage; and that the electing spouse has no actual knowledge unless otherwise stated.

1) Deficiency relates entirely to business income earned but not reported by H. Result : W who elects would have no liability.

2) Assessed deficiency is attributable to $70,000 of unreported business income of H and $30,000 of disallowed miscellaneous itemized deductions of W. Result : H, if he elects, would be liable for 70 percent of deficiency and W, if she elects, would be liable for 30 percent.

3) W has wages of $100,000 and H self-employment (Schedule C) income of $30,000 and $20,000 of Schedule C expenses are disallowed giving rise to a deficiency of $5,600. Result : Entire deficiency is allocated to H if W elects.

4) Same facts as in paragraph 3) above, except that self-employment income of H is only $15,000. Result : Of the disallowance, $15,000 would be allocated to H and $5,000 to W, if she elects, since H only benefited from $15,000 and wife benefited from the remainder. Thus, W would be liable for 1/4th of the deficiency. This result prevents any double tax benefit.

5) W has wages of $150,000 and H self-employment income of $30,000. Examination results in deficiency due to unreported additional $20,000 of self-employment income of H, of which W had actual knowledge of $5,000. Result : H is liable for entire deficiency and W, if she elects, is liable for deficiency attributable to additional $5,000 of income about which she had actual knowledge. IRS can collect 100 percent of deficiency from H and amount of deficiency attributable to the $5,000 from W.5

Burden of Proof. A joint filer seeking to make the election has the burden of proving his or her separate items of income and deduction to establish a separate portion of the tax deficiency.

Notice to Other Spouse. The IRS must promulgate regulations that establish procedures for giving the other spouse notice of and an opportunity to participate in any administrative proceedings ( i.e., appeals conference) with regard to the other spouse’s election of separate liability.6

Tax Court Review. A spouse who is denied innocent spouse treatment or the separate liability election may petition the U.S. Tax Court for a redetermination within 90 days after the mailing by the IRS of a determination or, if earlier, within six months after the election was filed.7 Except for special situations ( i.e., termination and jeopardy assessments), the IRS may take no collection action during the 90-day period or, if a Tax Court petition is filed, until the court’s order in the case becomes final.8 The Tax Court must establish rules to give the other spouse who did not make the election notice and the opportunity to become a party in the Tax Court proceedings.9 Tax Court review will be available to a spouse who was found not to have been an innocent spouse under prior law, i.e., there is no res judicata.

Revised and Liberalized Innocent Spouse Rule

Old IRC §6013(e) is repealed and replaced with new subsection 6015(b). The effective date is the same as for IRC §6015(c), the separate liability election.

This escape hatch will be available for those for whom the separate liability election is not available, i.e., those still married at time of collection activity, not legally separated, and not living apart for the 12-month period immediately preceding the initial IRS collection activity. The new liberalized requirements for innocent spouse treatment are: 1) a joint return was filed; 2) there is understatement of tax attributable to erroneous items in the return; 3) the “innocent spouse” establishes that, at the time of signing the return, he or she did not know and had no reason to know that there was an understatement; 4) taking into account all of the facts and circumstances, it is inequitable to hold the “innocent spouse” liable for the deficiency in tax; and 5) the “innocent spouse” elects, on a form to be created by the IRS, the benefits of §6015(b).

The election must be made not later than two years after the commencement of IRS collection activity on the deficiency in tax. Until the IRS creates a new form, the author suggests that taxpayer’s temporarily use existing Form 8857, Request for Innocent Spouse Relief. The spouse should write at the top of the form, “Election under IRC §6015(b),” and sign where indicated.

Result of Election

The electing “innocent spouse” is relieved of liability for the tax attributable to the understatement of income or overstatement of deductions.

Apportionment of Relief. The electing spouse is relieved of that portion of the liability arising from the understatement about which he or she did not know or had no reason to know. Thus, knowledge or constructive knowledge of some of the items giving rise to the deficiency does not prevent relief as to the other items.10

Note that there is no longer the problematic requirement that the understatement be substantial or that items be grossly erroneous. Note further that the §6015(b) election requires the lack of actual and constructive knowledge while the §6015(c) election requires only the absence of actual knowledge. Moreover, the electing spouse must still prove that he or she meets the other requirements, i.e., that a joint return has been filed, that he or she had no actual or constructive knowledge, and that it would be inequitable to hold this spouse liable. Since these standards existed under old §6013(e), presumably we may look to the case law under that section for guidance.

Requirement of a Joint Return. Under old §6013(e)(l)(A), “innocent spouse” relief is only available when a joint return has been filed. Although this requirement may appear somewhat unnecessary (if there were no joint return filed, there would be no joint and several liability and, therefore, no need for “innocent spouse” relief), it may be significant in certain cases.

No Actual or Constructive Knowledge. Generally, the test of whether a spouse had actual or constructive knowledge of the understatement, omission, or error is whether the spouse directly participated in the understatement, omission, or error or whether a reasonably prudent person in the spouse’s circumstances at the time of the filing of the return could be expected to know of the understatement, omission, or error.11 The key elements in determining whether the spouse “knew or should have known” or “questioned or should have questioned” include: 1) the “innocent” spouse’s level of education;12 2 ) unusual or lavish expenditures by the parties;13 3 ) participation in the business affairs or the business from which the understatement, omission, or error resulted;14 4 ) the ability of the “guilty” spouse to deceive;15 5 ) the extent of the innocent spouse’s involvement in family financial matters.16

Inequitable to Hold “Innocent Spouse” Liable. The test used is whether the “innocent spouse” benefited beyond normal support from the understatement, omission, or error. In other words, whether the parties’ standard of living substantially increased or whether the spouse seeking relief received funds in excess of that previously received.

A spouse may elect relief under both §6015(b) and §6015(c) if the spouse qualifies under both sections. If relief under neither §§6015(b) or (c) is available, the IRS has equitable authority under §6015(f) to make a determination that it is nonetheless inequitable, under all of the facts and circumstances, to hold a spouse liable for all or a part of the deficiency. If such finding is made, the person is relieved from liability. This may apply, for example, if a spouse thought that the tax had been paid but funds earmarked for payment of the tax were taken by the other spouse and used for that spouse’s exclusive benefit.17

The election of separate liability is an important development in the tax law affecting domestic relations lawyers. The author believes that in almost every case, the election should be made. Therefore, it is suggested that a mandate to make the election be incorporated into every marital settlement agreement with a concordant provision that the spouses will cooperate by exchanging information necessary to calculate their separate return liabilities. Proposed final judgments also should contain these provisions.

1 For a complete discussion of the old rules, see Frumkes and Steinberg, Florida Divorce Tax Made Easy, Professional Education Seminars, Inc. (Jan. 26, 1993) p. II-25 et seq.
2 Conference Committee Report (H.R. Conf. Rep. No. 105-599).
3 See Senate Committee Report (S. Rep. No. 105-174).
4 See Senate Rep., supra note 3.
5 Conference Committee Report, supra note 2.
6 I. R.C. §6015(g)(2).
7 I. R.C. §6015(e)(1)(A).
8 I. R.C. §6015(e)(1)(B).
9 I. R.C. §6015(e)(4).
10 I. R.C. §6015(b)(2).
11 Shea v. Commissioner, 780 F.2d 561 (6th Cir. 1986); Sanders v. United States, 509 F.2d 162 (5th Cir. 1975).
12 Raskin v. Commissioner, 41 T.C.M. 1195 (1981).
13 Estate of Jackson v. Commissioner, 72 T.C.M. 356 (1979).
14 Shapiro v. Commissioner, 51 T.C.M. 818 (1986); Cedrone v. Commissioner, 51 T.C.M. 555 (1986); Asmar v. Commissioner, 35 T.C.M. 930 (1976).
15 Mysse v. Commissioner, 57 T.C.M. 680 (1972); Bonhag v. Commissioner, 40 T.C.M. 250 (1980).
16 Nick B. Nicholas, 70 T.C. 1057.
17 Conference Committee Report, supra note 2.

Robert S. Steinberg is a forensic accountant who is admitted to the Florida and New York bars. He is a Florida Supreme Court certified family mediator and a C.P.A. and C.V.A. Mr. Steinberg serves on the ABA, Tax Section, Domestic Relations Committee and Family Law Section, Taxation Committee.

This column is submitted on behalf of the Family Law Section, Jane L. Estreicher, chair, and Sharon O. Taylor, editor.

Family Law