Protecting Innocent Spouses

The tax law provides limited protection to taxpayers whose spouses intentionally misstate their joint tax liabilities. In many marriages, one spouse handles the couple's financial affairs, including preparation of joint income tax returns. But what happens if that spouse intentionally mis-states income or deductions and thus understates the couple's tax liability? Is the other spouse liable for any resulting taxes, interest and penalties? The Internal Revenue Code's innocent spouse provisions, combined with case law, provide relief in limited situations. When a joint return is filed, IRC section 6013(d)(3) requires both taxpayers to be jointly and severally liable for any tax. Particularly after a divorce, one spouse may discover the other spouse reported taxable income incorrectly. Thus if taxes, interest and penalties are due, the innocent spouse is jointly and severally liable for the entire tax bill. Section 6013(e)'s innocent spouse provisions were enacted to address situations in which an innocent person, in addition to the government, was misled by a spouse who incorrectly reported taxable income. The law provides relief when it is inequitable to expect the innocent spouse to pay interest and taxes. The innocent spouse provisions were amended by the Tax Reform Act of 1984 to broaden the scope of relief. Recent cases suggest the Tax Court, supported by the Eleventh Circuit Court of Appeals, continues to restrict relief to very limited factual situations. The Second, Eighth and Ninth Circuit Courts of Appeals have interpreted the amendments more liberally. (The side-bar on page 65 outlines the geographic area these courts cover.) This article reviews the amendments and discusses the different standards applied by the courts. THE OLD RULES Before 1984, section 6013(e) established these criteria to be eligible for innocent spouse treatment: * A joint return must have been filed and gross income omitted. * The innocent spouse must establish that, in signing the return, he or she did not know of, and had no reason to know of, the omission. * It must be inequitable to hold the innocent spouse liable for the tax deficiency. Such a determination must take into account whether the innocent spouse significantly benefited, directly or indirectly, from the omission. This section generally was interpreted by the courts as applying to limited factual situations. Innocent spouse relief was available only when a court was convinced the innocent spouse had no knowledge of omitted income. Relief was not available when an innocent spouse was aware income had been omitted but did not understand its tax consequences. THE NEW RULES Congress broadened the scope of section 6013(e) in amendments to the TRA of 1984. In addition to omitted income, innocent spouse treatment was extended to cases of improper deductions, credits and cost-basis amounts. The amendments retroactively applied to all open tax years. Under section 6013(e)(1), four conditions are required for innocent spouse relief: 1. A joint return must have been filed. 2. A substantial understatement of tax must be attributable to one spouse's grossly erroneous items. 3. The innocent spouse must establish he or she did not know, and had no reason to know, of the substantial understatement. 4. In light of the facts and circumstances, it is inequitable to hold the innocent spouse liable for the resulting taxes. Section 6013(e)(2) defines grossly erroneous items as * Any income items the culpable spouse omitted from gross income. * Any deduction, credit or cost-basis claims by that spouse in amounts for which there is no basis in fact or law. In at least two cases, appeals courts differed with the Tax Court interpretation of the third requirement--knowledge of the transaction. …