The Innocent Spouse
The Pursuit of Equitable Relief, Separation of Liability, and/or Innocent Spouse Relief
The consideration of innocent spouse relief, separation of liability, and equitable relief remedies are important to understand and consider for the purposes for which they were created. This article presents the different options and when one option may be more fitting than another and the relief accorded under each.
The merging of two individualsâ€™ lives into the union of marriage has familiar practices: shared checking accounts, title to the marital home, and the filing of a joint tax return are a few of the more common mergers. The dissolution of that union, and the subsequent division of one back into two, is frequently not so fluid a process. While closing a joint checking account and executing a quit claim deed to a home require little more than filing paperwork, absolving oneself from the lasting ramifications of incorrectly filed joint tax returns, and the penalties which attach thereto, is not so easy.
Internal Revenue Code (IRC) Â§6013(d)(3) imposes joint and several liability on spouses who are married and file a joint tax return. This provision gives the IRS the latitude to collect any outstanding tax, in its entirety, from either spouse. Such joint and several liability cannot be waived or attributed to one spouse through a divorce settlement or legal separation, as the IRS is not bound by such agreements.
Clearly, such an imposition of liability on just one of the spouses can, at times, rise to the level of inequity. In particular, there are occasions in a marriage when one spouse is unaware of certain income earned by the other spouse, or situations when moneys provided by one spouse to pay taxes are misappropriated by the other spouse. It is for these legitimate situations that the â€śinnocent spouseâ€ť regulations of the IRC were implemented. IRC Â§6015 sets forth three forms of relief to a spouse from joint and several liability: (a) innocent spouse relief; (b) separation of liability; and (c) equitable relief.
Four universal rules apply to all three forms of relief: (1) a joint tax return must have been filed; (2) Form 8857, requesting the relief, must have been properly filed within the time limitations; (3) the request for relief must be from liability attributed to that spouse for income taxes; and (4) if a final judgment has been rendered by a court on the question of the income tax liability, and no request for relief was made during that proceeding, then the spouse is precluded from requesting relief thereafter.
The most commonly known, and cited to, form of relief from joint tax liability is innocent spouse relief. Innocent spouse relief shifts the responsibility for unpaid taxes, together with accrued interest and penalties, to the spouse who improperly reported or omitted items on the subject joint tax return. The burden of proof requires the spouse seeking relief to meet four enumerated conditions: (1) presence of erroneous items attributable to the non-seeking spouse; (2) no knowledge, whether actual or constructive, of the spouse seeking relief; and (3) a facts and circumstances test, which determines whether holding the innocent spouse liable would be unfair.
Step one of the innocent spouse test is the presence of erroneous items. Erroneous items occur in one of two forms: (1) as unreported income; or (2) as an incorrect deduction, credit or basis. Unreported income includes any gross income item received but which was not reported on the subject joint income tax return. Conversely, an improper deduction, credit or property basis is one which is claimed, in order to reduce taxable income and therefore the total tax burden to the couple, but which is never actually taken as a deduction or does not qualify as a deductible expense.
Factor two requires proof that the innocent spouse had no knowledge of the wrongdoing. The knowledge component is satisfied if the spouse seeking relief had no actual knowledge of the wrongdoing or can prove that a reasonable person in similar circumstances would not have known of the wrongdoing (constructive knowledge).
Finally, the third part of the test is a more subjective component. The facts and circumstances component of qualifying for innocent spouse relief essentially poses the question of whether holding both spouses responsible, in light of all facts and circumstances, is â€śfair and equitable.â€ť In determining whether holding both spouses liable is â€śfair and equitable,â€ť the IRS considers the current relationship of the spouses, if they are divorced or separated, whether the erroneous item actually resulted in a benefit, and whether the innocent spouse received a significant benefit as a result.
The second type of relief comes in the form of separation of liability. Separation of liability literally divides the understatement of tax, together with accrued interest and penalties, between the spouses, allocating an amount to each for which they are responsible. Separation of liability is unique among the three forms of relief in that it is available only for unpaid liabilities resulting from understatements of tax. It does not have the converse effect, which would allocate a refund among the two spouses and, like innocent spouse relief, it does not provide relief for underpayments of tax.
Qualification for separation of liability requires the spouses in question to be divorced or legally separated, or for the spouses to not have been members of the same household for the 12 months preceding the date on which relief was requested. As with innocent spouse relief, a separation of liability claim requires actual knowledge. If the innocent spouse can prove all or a portion of the tax deficiency is not attributable to him, such proof is sufficient to shift that portion of the liability to the other spouse. Evidence of fraudulent schemes or property transfers entered into for the purpose of tax avoidance is sufficient to preclude relief in a separation of liability claim. A transfer of property between spouses within one year of the IRS issuing a notice of deficiency is a rebuttable presumption that such transfer was for the purpose of avoiding taxes; naturally, such a presumption does not apply if the transfer was made pursuant to divorce decree, separate maintenance agreement, or other such similar written instrument.
The third and final form of relief is a â€ścatch-allâ€ť only available to spouses who do not qualify for either innocent spouse relief or separation of liability. Unlike innocent spouse relief and separation of liability, equitable relief is a remedy that is available for both understatements of tax and underpayments of tax. If relief was denied under either innocent spouse relief or separation of liability relief due to fraudulent schemes or tax avoidance, then a remedy under equitable relief is precluded as well. Equitable relief also requires that the tax liability, for which relief is being sought, be attributable to the non-seeking spouse.
The IRS allows claims for equitable relief to be divided into two categories: those on the fast-track (streamlined) and standard claims (non-streamlined). If a claim is placed in the streamlined category, relief is almost always granted, and the claimant has successfully shown that: (1) the spouses are divorced, legally separated, or have not been members of the same household for the preceding 12 months; (b) economic hardship will result to the innocent spouse if relief is not granted; and (c) the innocent spouse did not know of the deficiency or did not have reason to know the spouse would not, or could not, pay the deficiency. Â
Conversely, the non-streamlined criteria is more of a balancing test, rather than a set of rigid criteria, to determine whether holding both spouses liable is fair and equitable. The following factors are considered in such a balancing test:
- Whether the spouses are divorced or legally separated and, if separated, whether the separation is temporary.
- Whether the spouse seeking relief will suffer a significant economic hardship if relief is not granted.
- Whether any legal obligations exist, pursuant to a divorce decree or separation agreement, requiring one spouse to pay the tax.
- Whether a significant benefit, beyond normal support, as a result of the unpaid tax or item causing the tax understatement, was received.
- Whether a good faith effort to comply with federal income tax laws was made, not only in the year for which an error or omission occurred, but in subsequent years as well.
- Whether the spouse seeking relief knew or had reason to know that the items causing the understatement or tax would not be paid.
The increased awareness of spouses suffering in abusive or domineering relationships, and subsequent hardships they face in attempts to meet the standards for relief, are considered not only in the streamlined procedures, but also in the â€śweightâ€ť accorded to each of the factors considered in the non-streamlined test. To serve this end, greater weight may be placed on spouses who have suffered from domestic abuse to the point of negating other factors which, previously, would have been sufficient for denial of relief.
The consideration of innocent spouse relief, separation of liability, and equitable relief remedies are important to understand and consider for the purposes for which they were created. In particular, the equitable relief remedy and its implementation as a â€ścatch-allâ€ť has been important to claims which do not meet the innocent spouse relief or separation of liability tests but for which real inequity could or would exist without relief. Where such claims have been raised, the remedies available pursuant to such claims could be carefully considered and implemented as necessary.
Elizabeth Ciccone, ASA, Esq., is a partner in Marcum LLPâ€™s Advisory Services practice. Ms. Ciccone specializes in matrimonial litigation and collaborative and non-adversarial divorce. She has also performed valuations of business interests for a variety of purposes including, but not limited to, business shareholder litigation, and estate and gift tax matters.
Ms. Ciccone can be contacted at (203) 781-9767 or by e-mail to Elizabeth.Ciccone@marcumllp.com.