Innocent spouse considerations for parties contemplating a joint return.by Schacter, Alan
Advisors to parties in a matrimonial proceeding should be cognizant of the innocent spouse provisions of the IRC in those cases where separated parties are contemplating filing a joint return. Many unsuspecting spouses have been left with the legacy of large assessments for taxes, interest and penalties relating to deficiencies attributable to their share of the reported revenues and expenses reflected on the joint tax return.
Before the Innocent Spouse
Act of 1971
Prior to the adoption of the Innocent Spouse Act of 1971, a husband and wife that filed a joint tax return were almost always jointly and severally responsible for the tax deficiencies, interest and penalties created by that filing. However, Secs. 6013(e) and 6653(b)(4) provided relief to an innocent spouse under certain conditions. The conditions include:
* Spouses filed joint tax return;
* An omission of gross income attributable to one spouse which exceeded 25% of the gross income stated on the return;
* The innocent spouse did not know and had no reason to know of the omission from income when signing the return; and
* Taking into consideration all of the facts and circumstances, particularly whether the innocent spouse significantly benefited from the omitted items, it was inequitable to hold the innocent spouse liable for the deficiency.
In addition, Sec. 6653(b)(4) was enacted as a companion to Sec. 6013(e) to provide relief from the then 50% civil fraud pealty when a fraudulent act was attributable solely to the other spouse.
These provisions were a step forward; however, inequitable situations still arose because the tax liabilities generated as a result of fraudulent deductions, tax basis issues, and credits were not covered by the 1971 changes. In addition, many high income couples fell short of the 25% of gross income threshold, therefore, leaving one spouse unjustly accountable for a substantial joint income tax assessment subsequent to an IRS audit. As a part of TRA 84, Conress responded to these inequities by retroactively amending, Sec. 6013(e).
Currently, a spouse will be relieved of tax, interest, and penalty and deemed an innocent spouse if all of the following conditions are met under revised Sec. 6013(e):
* A joint return has been filed for the taxable year in question;
* There is a substantial understatement of tax attributable to a grossly erroneous item;
* The other spouse establishes that in signing the return he or she did not know and had no reason to know that there was a substantial understatement; and
* All facts and circumstances indicate that it is inequitable to hold the other spouse liable for the deficiency in tax for that year relating to the substantial understatement.
A substantial understatement is defined as understatement of tax which exceeds $500. However, the tax liability must also exceed certain percentages of the innocent spouse's gross income when it relates to grossly erroneous deductions, tax basis issues, and credits for which there is no basis in fact or law. If the innocent spouse's adjusted gross income is $20,000 or less, relief will only be granted if the liability (including interest and penalties) exceeds 10% of adjusted gross income for the preadjustment year, which is defined as the spouse's most recent taxable year ending before the date of the notice of tax deficiency issued from the IRS. The percentage increases to 25% if adjusted gross income exceeds $20,000 in the preadjustment year. Ironically, the IRC also provides that if a spouse is remarried before the end of the preadjustment year the combined adjusted gross income of the spouse and his or her new spouse will be used for the 10% or 25% of adjusted gross income tests.
Therefore, there is a dual threshold for a substantial understatement relating to gross erroneous deductions, tax basis items and credits. However, for omissions of gross income only the $500 threshold is applicable. A grossly erroneous item is any omitted item of gross income and any claim for deductions, tax basis, or credit in an amount for which there is no basis in fact or law.
Illustration of New Rules
As an illustrations, in year 1 a fraudulent deduction is taken by one spouse on a joint return, and the other innocent spouse is unaware of the nature of the deduction. In year 2 the spouse obtains a divorce. In year 3 the innocent spouse remarries and has adjusted gross income of $60,000. His or her new spouse has adjusted gross income of $20,000. In year 4 a deficiency notice is mailed with respect to the fraudulent deduction taken in year 1. Unless the tax liability attributable to the disallowance of the deduction exceeds $20,000 (25% of $80,000) innocent spouse treatment will not be available. However, if in the above example the deficiency was related solely to an omission of gross income, then only the $500 substantial understatement threshold would apply, and the calculations related to the preadjustment year adjusted gross income would be unnecessary. This appears to be an inequitable result. Many have argued that issues relating to grossly erroneous and unfounded deductions, basis, and credits should be given the same treatment as omission of gross income. But they do not, as the law and cases exist currently.
Need for Further Explanation
The basis statutory outline requires further explanation in those areas which tend to be the most litigated. For example, were the requirements for filing a joint return met?
* Taxpayers must be husband and wife at year end;
* Neither spouse was a nonresident alien at the end of the year;
* Their taxable years are the same;
* Tax returns may be filed by husband and wife or their agents if they elect;
* The joint return must be signed by both spouses or their agents, if they elect; and
* The joint return must include their aggregate income and deductions.
Even if the statute is not compiled with, the courts may inquire into the subjective intent of the parties. Many problems arise where one spouse signs the other's name as a purported agent, or when one spouse refuses to sign. Usually the courts have held that if a spouse did not sign because he or she actively refused to risk the burden of joint and several liability, particularly under the advice of counsel, no joint return will be deemed filed. However, if the spouse refused to sign for different reasons, such as to gain leverage in divorce negotiations, but other factors demonstrate the intent to share in the benefits and burdens of a joint return, such a return may be deemed filed even without the other party's signature.
On the other hand, where both parties signed the return, relief will only be granted because of duress, undue influence, misrepresentation or mistake.
Lack of Knowledge
In considering whether a spouse had reason to know of omission from gross income under the 1971 provisions, the tax court considered several criteria that are applicable in the current state of the law:
* Unusual or lavish expenditures by the parties during the tax years;
* Participation in business and bookkeeping activities of either spouse' financial dealings and level of education;
* The guilty spouse's refusal to be forth-right about the couple's income; and
* Evidence that a spouse had "reason to know," the return was erroneous, for example if a spouse in similar circumstances at the time of signing the returns could be expected to know if was erroneous or that further investigation was warranted.
The innocent spouse's ignorance must exist until the tax return is filed and not just for the year to which the return relates.
An individual's level of education, involvement in business, and other experience may be crucial in the determination of constructive knowledge. A spouse doesn't qualify if "the lack of knowledge" of the omitted income is predicated on mere ignorance of the legal consequences of transactions, the facts of which are either in the possession of the spouse seeking relief or reasonably within his or her reach. This appears to be a harsh result and this case should be read very carefully. It may have sweeping consequences to a spouse where the broad circumstances to a transaction are known but the details are not. The McCoy result was carried over to the tax shelter area where the wife knew the basis of the investment was purely for tax purposes.
Did the Spouse Have
Many of the cases in the innocent spouse area him hinge on the determination of whether the spouse had knowledge or constructive knowledge of the erroneous items on the return. There are situations where a spouse may know that the other spouse is a drug dealer or in some other illicit business.
During the year lavish expenditures are made which are not conceivably based on the family's standard of living and sources of income. In these situations it is very difficult to obtain innocent spouse treatment particularly where the innocent spouse received substantial direct or indirect benefits of these erroneous or omitted items. Sometimes these spouses are not granted innocent spouse treatment, and they may even be deemed criminal co-conspirators in a later criminal proceeding.
Inequity to Hold Spouse
Liable Based on All of the
Facts and Circumstances
There has been no real change in this area since 1971. The basic question is whether a spouse seeking relief significantly benefitted directly or indirectly from the erroneous items (ordinary support is excluded). Other factors that may be considered, as stated in the regulations, are whether the relief seeker has been deserted by his or her spouse or is divorced or separated.
The facts and circumstances test allows the IRS some latitude in dealing with these cases, particularly when benefits do not flow to the other spouse. For example: wife was a quiet, hard-working homemaker, recently separated from her flamboyant, playbody husband. However, she dutifully signed the joint income tax returns every year without any knowledge of her husband's illicit activities. The husband lived in the fast lane, generated substantial sums of cash, and spent heavily on drugs, women and other forms of entertainment, but spent very little on his wife. In this case, innocent spouse status for the wife was preserved. This was crucial to the case because the martial residence, worth $1 million, was solely in her name and could not be seized as part of any IRS collection proceeding.
No Basis in Fact or Law
As previously mentioned, any amount of omitted gross income is deemed a grossly erroneous item eligible for innocent spouse consideration provided the other aforementioned factors are present. However, deductions, tax basis issues and credits are not considered grossly erroneous except when they are reported on the return and there is no basis in fact or law for them. Once they pass this threshold test the items are then factored into the 10% and 25% adjusted gross income tests related to the preadjustment year of the spouse seeking relief.
In Douglas v. Commissioner the court stated, "The statute does not define 'no basis in fact or law.' A clue to its meaning, however, is found in the reference in the above-quoted committee report to 'phony business deduction.' As we read the statute as a whole, and its legislative history, a deduction has no basis in fact when the expense for which the deduction is claimed was never, in fact, made. A deduction has no basis in law when the expense, even if made, does not qualify as a deductible expense under well-settled legal principles or when no substantial legal argument can be made to support its deductibility. Ordinarily, a deduction having no basis in fact or in law can be described as frivolous, fraudulent, or, to use the word of the committee report, phony."
The content of this decision and others indicate that the courts will not grant relief in the deductions, credit, or basis areas unless they are dealing with totally bogus items.
The innocent spouse provisions of the Code must be considered when parties going through a matrimonial proceeding are considering filing a joint return. It is an area where there has been a substantial amount of litigation, and it appears that Congress has not solved all of the inequities in the 1984 revisions. The specific facts and circumtances of each case are critical.
Proper cross indemnification agreements are a necessity for parties filing jointly in a matrimonial proceeding. It may be several years after the divorce that the parties become aware of their tax problems. If a successful innocent spouse case is not built and there is no indemnification agreement between the parties, the spouse seeking relief may be facing a substantial tax liability for both federal and state purposes with no recourse but to, hopefully, work out an extended payment agreement with the collection offices of the various taxing and authorities.
Careful thought and planning must be given to the filing of a joint return during a matrimonial proceeding. Many attorneys require accountants to closely scrutinize each item on a proposed joint return. When the return look questionable or where unsatisfactory or no responses are received to inquires as to the substantiation for transactions and entries on the return, or one spouse is involved in possible illegal activities, good advice suggests that separate returns be filed. This will avoid the rather burdensome task of litigating an innocent spouse case.
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