The Innocent Spouse Rule: Variations on a Theme
When a couple gets married, joint returns typically are filed. The husband and wife
are responsible jointly and individually for payment of correct taxes on their taxable income. One spouse may contribute little or no income to annual taxable family income, but will still be liable if the other spouse understated the amount of income tax due.
In some situations, one spouse may not be aware of incorrect tax reporting by the other spouse. Upon separation or divorce, one spouse probably will have even less knowledge of the other spouse’s reporting for tax purposes. The IRS, in its role as a muscular creditor, not surprisingly insists on full payment of the taxes due. If the spouse responsible for the incorrect reporting has insufficient assets to pay the tax bill, IRS collections likely will demand the balance from the other spouse, whether the parties are still together, separated, or divorced.
The “innocent spouse” rule was developed in order to protect spouses with no knowledge of the incorrect tax reporting of the other spouse. Congress enacted the first “innocent spouse” provision in 1971, and modifications to the law were made in 1984. The rule provided limited relief, and in some circumstances created harsh results.
The IRS Restructuring and Reform Act of 1998, signed into law by President Clinton on July 22, 1998, gives further relief to innocent spouses by making the old rules more flexible. Nevertheless, the changes have created new questions that will need to be addressed by Congress.
The Old Law
Basic Requirements. Prior to the statutory changes made in 1998, the Internal Revenue Code (IRC) obliged the innocent spouse to establish: 1) that a joint return was made; 2) that an understatement of tax, which exceeded the greater of $500 or a specified percentage of the innocent spouse’s adjusted gross income for the most recent taxable year prior to the date the deficiency notice was mailed, was attributable to a grossly erroneous item of the other spouse; 3) that in signing the return, the innocent spouse did not know, and had no reason to know, that there was an understatement of tax; and 4) that taking into account all the facts and circumstances, it would be inequitable to hold the innocent spouse liable for the deficiency in tax.1 The innocent spouse carried the burden of proof.2 A failure to prove any one element would prevent such person from qualifying as an “innocent spouse.”3
Significant Understatement of Tax. One requirement was that the tax understatement be the greater of $500 or more than 10 percent of the innocent spouse’s adjusted gross income if the spouse’s income was $20,000 or less.4 If the spouse’s income was $20,000 or more, the specified percentage had to be more than 25 percent.
Grossly Erroneous Items. The old law required not only that there be a certain understatement of tax, but also that there be gross reporting errors attributable to the “guilty” spouse. Grossly erroneous items included unreported income and any deductions, credits, or property bases claimed for which there was no basis in fact or law.5 A misunderstanding of the tax consequences of a sale did not qualify.6 Failure to provide sufficient evidence to convince the IRS of a tax position did not necessarily rise (or sink) to the level of “grossly erroneous.”7
In IRS Publication 971 (Innocent Spouse Relief) (4/98), the following examples of “grossly erroneous” are given:
(1) The expense for which the deduction is taken was never made. (For example, your spouse deducted $10,000 of advertising expenses of Schedule C (Form 1040), but never paid for any advertising.) (2) The expense does not qualify as a deductible expense under well-settled legal principles. (For example, your spouse claimed a business fee deduction of $10,000 that was for the payment of state fines; fines are not deductible.) (3) No substantial legal argument can be made to support the deductibility of the expense. (For example, your spouse claimed $4,000 for security costs related to a home office, which were actually veterinary and food costs for your family’s two dogs.)
Reason to Know. The court in Sanders v. United States, 509 F.2d 162, 167 (5th Cir. 1975), held that a spouse had “reason to know” if a reasonably prudent taxpayer under the circumstances of the spouse at the time of signing the return could be expected to know that the tax liability stated was incorrect or that further investigation was in order. Therefore, the alleged innocent spouse was under a duty to “ask questions.” If an alleged innocent spouse stayed at home and did not challenge the other spouse’s judgment concerning the family finances, such passivity would not establish that there was no “reason to know.”8
Actions taken by the spouse claiming innocence were reviewed to see if they were consistent with ignorance of the other spouse’s affairs. Factors considered in determining whether there was a “reason to know” include the alleged innocent spouse’s level of education,9 degree of involvement in the family’s business and finances,10 and the culpable spouse’s deceit concerning the couple’s finances.11 However, ignorance of the tax consequences of signing the joint return has been rejected as an extenuating circumstance.12
Expenditures that were lavish or unusual in comparison to the family’s past standard of living could also be a “warning flag.”13 In Stevens v. Com’r, 872 F.2d 1499 (11th Cir. 1989), the court noted that the appellants had a lavish lifestyle that was relevant in determining whether the wife had reason to know of the validity of the large deductions being taken. The husband had formed a broker/dealership in Sarasota that sold life insurance annuities and tax shelters. The wife performed secretarial functions. The business did increasingly well, and the couple bought property such as Florida beachfront real estate, a houseboat, and twin Jaguar convertibles. The court found that she had enough “clues” to create suspicions, stating that a “spouse cannot harbor doubts about the accuracy of a return and then turn a blind eye toward it.”14
In Kistner v. Com’r, T.C. Memo 1995-66, the Tax Court in following the direction of an 11th Circuit reversal, found that a lavish lifestyle did not block relief under the innocent spouse rules. In this case, the wife married her husband at age 17 and did not complete high school. The husband became a wealthy radish farmer. The IRS issued deficiency notices for the years 1979 and 1980 on the grounds that the couple did not report more than $1 million of income. This amount was made up largely of constructive dividends so treated by the IRS because the corporation was paying many of the couple’s personal expenses. The receipt of the constructive dividends, however, was found not to have improved the family lifestyle.
Missing the Filing Date. Many spouses, especially former spouses, realized that they were subject to further tax liability only after the deadline for petitioning the Tax Court had come and gone. With a deficiency assessment imposed, suit might be filed in United States district court or the Court of Federal Claims. However, tax, interest, and penalties would have to be paid first.
Changes Made in 1998
Changes. Congress enacted §6015 of the Internal Revenue Code. The 1998 tax law makes innocent spouse status easier to obtain in several ways. For example, the understatement requirements are gone.15 Also, the understatement of tax must relate to an erroneous as opposed to a grossly erroneous tax item of the other spouse. Further, taxpayers are now given a two-year window within which an election for relief can be filed. The two-year period begins when the IRS begins collection activities. The new legislation applies to any liability for tax arising after July 22, 1998, and any liability for tax arising on or before such date but remaining unpaid as of that date. The IRS is supposed to have new forms available by December 22, 1998.
Under the new law, the innocent spouse may seek relief if such spouse has made a joint tax return and if the following requirements are met: 1) on the joint return there is an understatement of tax attributable to erroneous items of the “non” innocent spouse; 2) the innocent spouse filing the joint return establishes that in signing the return he or she did not know, and had no reason to know, that there was such understatement; 3) taking into account all the facts and circumstances, it is inequitable to hold the innocent spouse liable for the deficiency in tax for such taxable year attributable to such understatement; and 4) the innocent spouse elects such benefits no later than two years after the date the IRS has begun collection activities with respect to the individual making the election.16 If the above requirements are met, then the innocent spouse is not liable for tax (including interest, penalties, and other amounts) for such taxable year to the extent such liability is attributable to the understatement.
The new law also builds in some flexibility with regard to the knowledge or reason to know requirement. If the innocent spouse has knowledge of a portion of the understatement, but otherwise meets the prerequisites for relief, the innocent spouse is only responsible for the tax (and interest, penalties, and other amounts) relating to that portion.17 Proof is required, as before, to show lack of knowledge (as well as no reason to have such knowledge) to the specific item(s) of tax liability.
Separate Rules for Divorced and Separated Taxpayers. The new law establishes separate elective rules for taxpayers who are no longer married or who are legally separated or not living together.18 Under these rules, the divorced or separated individual’s liability for any assessed deficiency cannot exceed the portion of such deficiency considered allocable to the individual.19 Individuals who are divorced, separated, or no longer living together can elect a tax regime that is different from the provisions relating to “innocent spouses.”20 Spouses who still remain married and live together are barred from taking advantage of this alternative election.
The electing taxpayer carries the burden of proof to establish the allocable deficiency allocable to the taxpayer.21 The IRS, however, has the burden of proof to show that assets were transferred between individuals as part of a plan to defraud the IRS.22 The IRS also has the burden of proof to show that at the time the joint return was signed, an individual had actual knowledge of an item creating a deficiency that was not allocable to such individual.23 If the taxpayer can show that the return was signed under duress, actual knowledge is permissible.
If an election is made, any tax deficiency for which an individual is liable is to be increased by the value of a “disqualified asset” transferred to the individual.24 An asset is disqualified if transferred by one individual to the other for the principal purpose of avoiding tax or the payment of tax. There is a statutory presumption that any transfer made one year before the date of the first letter of proposed deficiency is made for the principal purpose of avoiding tax or the payment of tax.25
An election for any taxable year must be made not later than two years after the IRS has begun collection activities with respect to the separated or divorced individual making the election.26
The new law provides for the proportional allocation of deficiency.27 The portion of the tax deficiency to be allocated to the electing spouse is based on the proportion of items allocable to the individual over the total amount of tax deficiency items.28 The Conference Committee Report for the bill provides an example:
[A] deficiency is assessed that is attributable to $70,000 of unreported income allocable to the husband and the disallowance of a $30,000 miscellaneous itemized deduction allocable to the wife. If the spouses who joined in the return are no longer married, are legally separated, or have lived apart for at least 12 months, either may elect limited liability under this provision. If either the husband or the wife elect, the husband’s liability would be limited to 70 percent of the deficiency (if he elects) and the wife’s liability limited to 30 percent (if she elects). This would be the case even if a portion of the miscellaneous itemized deductions had been disallowed under section 67(a).29
The burden of proof is on the individual making the election to establish the deficiency allocable to him or her. The question of who makes the election could be important.
In making the allocation, the IRS looks to how the items giving rise to the tax deficiency would be allocated if the individuals had filed separate returns for the taxable year.30
Petition for Review by Tax Court. If an individual elects treatment under the revised “innocent spouse” rule or the rule for divorced or separated spouses, the individual may petition the Tax Court to determine the appropriate relief. The petition must be filed during the 90-day period beginning on the date on which the IRS notifies such individual of the tax relief available.31 The individual may nonetheless file the petition six months or more after the date such election is filed with the IRS and before the close of the 90-day period.32 The IRS is also given authority to promulgate rules providing for equitable relief if such relief is not available under the “innocent spouse” rules or the rules for divorced and separated individuals.33
And Now?
The changes made to the innocent spouse rule help to eliminate some of the complaints pertaining to the old statutory formulation. The removal of a specified understatement amount is helpful. So is the removal of the old “grossly erroneous” standard in favor of the more flexible “erroneous” standard. The “reason to know” requirement remains, at least for married spouses living together, and will continue to be a litigated matter. Interpretative cases are in plentiful supply, but “reason to know” is a highly fact-dependent standard. The taxpayer seeking innocent spouse will need to provide the proof to meet this requirement.
The alternative rule for individuals no longer married, legally separated, or not living together poses some interpretative challenges. Also, having two different approaches to escape the general rule of joint and several tax liability seems unnecessarily complicated. Generally speaking, the new code provisions appear to incorporate two different policy choices. One choice requires the spouse to show that he or she did not know, or had no reason to know, about the tax error or misdeed. The other choice puts the burden on the IRS to show fraud or actual knowledge with respect to a tax deficiency not attributable to the electing spouse. Congress has decided to make the more difficult standard apply to the spouse who chooses to continue to live with the other spouse. q
1 I.R.C. §6013(e).
2 See Purcell v. Com’r, 826 F.2d 470, 473 (6th Cir. 1987), cert. denied, 485 U.S. 987.
3 Shea v. Com’r, 780 F.2d 561, 565 (6th Cir. 1986).
4 I.R.C. §6013(e)(4)(A).
5 I.R.C. §6013(e)(2).
6 Bokum v. Com’r, 992 F.2d 1132 (11th Cir. 1993).“It does not necessarily follow that every deduction that is disallowed is necessarily ‘groundless.’” Bokum, 992 F.2d at 1142.
7 See Feldman v. Com’r, 20 F.3d 1128 (11th Cir. 1994) (Husband and wife who owned equal share of partnership failed to prove profit motive for partnerships, but court found that deductions taken were not “grossly erroneous” even though penalty interest rates were imposed.)
8 See Shea, 780 F.2d at 556.
9 Probinsky v. Com’r, T.C. Memo 1988-371 (husband age 61; wife age 23, with high school education and who worked as a photographer).
10 See Guth v. Com’r, 897 F.2d 441 (9th Cir. 1990), criticized but followed in Pulliam v. Com’r, T.C. Memo 1994-609 (husband had complete control of family finances).
11 Sanders, 509 F.2d at 167.
12 Park v. Com’r, 25 F.3d 1289, 1293–94 (5th Cir.), cert. denied, 513 U.S. 1061 (1994).
13 Id.
14 Stevens, 872 F.2d at 1504.
15 “Understatement” is defined at I.R.C. §6662(d)(2)(A), which is in general the amount of the tax required to be shown on the tax return for the taxable year over the tax actually on the return.
16 I.R.C. §6015(b)(1).
17 I.R.C. §6015(b)(2).
18 The individual may not be a member of the same household as the individual with whom the joint return was filed at any time during the 12-month period ending on the date of the filing of the election. I.R.C. §6015(c)(3)(A)(i)(II).
19 I.R.C. §6015(c)(1).
20 See Toni Robinson and Mary Ferrari, The New Innocent Spouse Provision: “Reason and Law Walking Hand in Hand”?, Tax Analysts: Doc 98-25818 (8/17/98), for a description of the legislative history. The differences are the result of the merger of different legislative proposals in the House and Senate.
21 I.R.C. §6015(c)(2).
22 I.R.C. §6015(c)(3)(A)(ii). Treasury has the power to issue regulations making different allocations in the case of fraud.
23 I.R.C. §6015(c)(3)(C).
24 I.R.C. §6015(c)(4)(A).
25 I.R.C. §6015(c)(4)(B)(ii)(I). There is an exception for any transfer pursuant to a decree of divorce or separate maintenance or a written instrument incident to such a decree or to any transfer which an individual establishes did not have as its principal purpose the avoidance of tax or payment of tax. I.R.C. §6015(c)(4)(B)(ii)(II).
26 I.R.C. §6015(c)(3)(B).
27 I.R.C. §6015(d)(1). If a deficiency is attributable in whole or in part to the disallowance of a credit or any tax (other than tax imposed by §1 or §55) required to be included with the joint return; and such item is allocated to one individual, such deficiency (or portion) shall be allocated to such individual. I.R.C. §6015(d)(2).
28 I.R.C. §6015(d)(1).
29 Joint Explanatory Statement for Conference Committee for HR 2676 (at ¶365, relating to §321 of the House Bill and §3201 of the Senate Amendment).
30 I.R.C. §6015(d)(3)(A). There are exceptions where an item giving rise to a deficiency had provided a tax benefit to one spouse on the joint return, or if there was fraud by one or both individuals. I.R.C. §6015(d)(3)(B) and (C). If a deduction or credit is completely disallowed simply because a separate return is filed, the disallowance is disregarded and the item is computed as if a joint return had been filed. See I.R.C. §6015(d)(4). A taxpayer’s child’s liability included on a joint return is disregarded and allocated appropriately between the spouses. See I.R.C. §6015(d)(5).
31 I.R.C. §6015(e)(1)(A).
32 Id. There are also certain restrictions regarding the collection of the assessment (I.R.C. §6015(e)(1)(B)), suspension of the period of limitations for the collection of the assessment (I.R.C. §6015(e)(2)), allowance of credit or refund (I.R.C. §6015(e)(3)(A)), res judicata (I.R.C. §6015(e)(3)(B)), Tax Court jurisdiction (I.R.C. §6015(e)(3)(C)), and notice to the other spouse (I.R.C. §6015(e)(4)).
33 I.R.C. §6015(f). Treasury guidelines are needed.
Joseph B. McFarland received a B.A. from Princeton University, an M.A. from Johns Hopkins University (SAIS), a J.D. from New York Law School, and an LL.M. in taxation from the University of Florida. His practice is focused on international tax planning for individuals and businesses.
This article is submitted on behalf of the Tax Section, J. Bob Humphries, chair, and Michael D. Miller and Lester B. Law, editors.
