Innocent Spouse Prop. Regs. Offer Relief

The innocent spouse relief provisions included in the Internal Revenue Service Restructuring and Reform Act of 1998 have now been explained in proposed regulations. The rules address innocent spouse relief, the deficiency-allocation election and equitable relief. This article's many examples provide guidance through the regulatory maze.

Nancy J. Foran, Ph.D., CPA
Associate Professor
University of Michigan–Dearborn
Dearborn, MI

Michael F. Foran, Ph.D., CMA, CIA, CPA
Associate Professor
University of Michigan–Dearborn
Dearborn, MI

For more information about this article, contact Dr. Nancy J. Foran at (313) 593-1379 or nforan@umd.umich.edu .

Executive Summary

Sec. 6015 offers three categories of JSL relief: (1) innocent spouse relief; (2) deficiency allocation by taxpayers no longer married, legally separated or not living together; and (3) equitable relief.

If an RS had actual knowledge of an erroneous item when the joint return was signed, he remains liable for the deficiency attributable to that item.

The number of innocent spouse cases received by the IRS has increased from 3,000 to 5,000 new cases per month.

Earlier this year, Treasury issued proposed regulations¹ on the innocent spouse rules enacted by the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98). The regulations apply to liabilities arising after July 22, 1998, and to those arising before that date but unpaid before July 23, 1998. The rules will be effective for relief elections and requests filed on or after the date the final regulations are published.

Background

Sec. 6013(d)(3) imposes joint and several liability (JSL) on married couples filing jointly. JSL allows the government to collect a tax liability (including penalties and interest) from either spouse. Prior to the enactment of the IRSRRA '98, Sec. 6013(e) provided JSL relief to an innocent spouse only for large tax understatements and grossly erroneous items. In 1998, Congress replaced Sec. 6013(e) with Sec. 6015 in the belief that the prior law did not adequately remedy the JSL issue.² Sec. 6015 offers three categories of JSL relief: (1) innocent spouse relief; (2) deficiency allocation by taxpayers no longer married, legally separated or not living together; and (3) equitable relief.

JSL Relief

To obtain JSL relief, a "requesting spouse" (RS) may submit a single claim electing innocent spouse relief and/or a deficiency allocation and requesting equitable relief. Form 8857, Request for Innocent Spouse Relief (And Separation of Liability and Equitable Relief), can be used to submit the "election" or "request." (Terms in quotes are defined in Exhibit 1.)

According to Prop. Regs. Sec. 1.6015-1(a)(2), innocent spouse relief and a deficiency allocation must be affirmatively elected. If an RS makes an election, the IRS may determine that an alternative election may be more appropriate. If both elections are inappropriate, the Service can decide whether equitable relief should be granted. However, if only equitable relief is requested and cannot be granted, the IRS cannot consider either of the elective provisions.

Income, credit and deduction items are allocated to spouses without regard to community property laws. An "erroneous item" is attributed to the spouse whose activities produced the item.

Example 1: A and B filed joint returns and lived in a community property state that attributes one-half of all income earned and property acquired during marriage to each spouse. They later divorced. The IRS assessed a deficiency attributed to $75,000 of A's unreported income and $25,000 of B's disallowed deductions. B elects to allocate the deficiency. Although the state provides that one-half of the unreported income is attributable to B, for purposes of JSL relief, the $75,000 of unreported income is attributable to A; the $25,000 of disallowed deductions are attributable to B.

Knowledge of Erroneous Items

Of the three JSL relief categories, only innocent spouse relief and the deficiency allocation explicitly contain a knowledge requirement. However, that requirement differs as to the level of knowledge and which party bears the burden of proof. Although neither the Code nor the regulations specify a knowledge requirement for the equitable-relief category, Rev. Proc. 2000-15³includes a knowledge requirement in its list of circumstances under which equitable relief will ordinarily be granted and factors to consider in determining whether it would be inequitable to hold an RS liable.

To obtain innocent spouse relief, an RS must demonstrate that he had no (1) reason to know and (2) actual knowledge of the "item" that produced the understatement when the return was signed. Partial relief is allowed if a spouse had no reason to know and no actual knowledge of a portion of an erroneous item, but the RS bears the burden of proof.

In contrast, a deficiency-allocation election is valid unless the IRS can demonstrate that the RS had actual knowledge (at the time the return was signed) of an erroneous item allocable to the "nonrequesting spouse" (NS). Thus, the knowledge requirement does not include a reason to know; the Service bears the burden of proof.

Prop. Regs. Sec. 1.6015-1(g)(3) defines an "item" as that which is required to be separately stated on an individual return or a required attachment. However, investment amounts received from the same source are aggregated and treated as one item.

The equitable-relief knowledge requirement, as described in Rev. Proc. 2000-15, differs from the other two relief categories. Equitable relief will ordinarily be granted if, among other things, at the time the return was signed, the RS had no reason to know and no knowledge that the tax would not be paid. In addition, an RS must establish it was reasonable to believe that the other spouse would pay the tax. Thus, the reason-to-know and knowledge components are similar to that in the innocent spouse relief category. However, the knowledge relates to the payment of the tax, not the item that resulted in the understatement.

An RS who would otherwise qualify for equitable relief, except for the fact that he had partial knowledge, may be granted partial relief. If an RS does not meet the conditions for equitable relief, relief nevertheless may be granted if, taking into account all the facts and circumstances, it would be inequitable to hold the RS liable for all or part of the unpaid liability or deficiency. One factor is whether the RS had reason to know or knew (1) that the reported liability would not be paid or (2) of the item that produced the deficiency. In this case, the definition of knowledge as to an item that results in a deficiency is the same as in the innocent spouse relief category.

Reason to Know

The "knowledge or reason to know" requirement is met if an RS either actually knew of the item or if a reasonable person in similar circumstances would have known of the item. Because actual knowledge applies to all relief categories, it is discussed in detail below.

According to Prop. Regs. Sec. 1.6015-2(c), reason to know is determined by considering all the facts and circumstances, such as the (1) nature of the item; (2) amount of the item relative to other items; (3) couple's financial situation; (4) RS's educational background, business experience and participation in the activity; and (5) RS's inquiry (i) at or before the return was signed, about items on or omitted from the return that would be questioned by a reasonable person or (ii) whether items deviated from a recurring pattern in prior-year returns.

Partial Relief

RSs who have no knowledge or reason to know of a portion of an erroneous item may obtain innocent spouse relief for that portion. (This rule does not apply to deficiency allocations.)

Example 2: C failed to report $10,000 of taxable interest on C and D's joint return. If D knew that C received the interest, D had actual knowledge and could not receive relief for the deficiency attributable thereto. If D knew of only $3,000 of the $10,000 of taxable interest, he could not receive relief for the deficiency attributable to $3,000 of the interest, but could receive relief for the deficiency attributable to the $7,000 remainder.

Actual Knowledge

The actual-knowledge factor applies to all relief categories. If an RS had actual knowledge of an erroneous item when the joint return was signed, he remains liable for the deficiency attributable thereto. The following concepts and examples apply to all relief categories; they assume that all of the requirements for a deficiency allocation are met and the only issue is knowledge.

Knowledge of return treatment irrelevant: An RS's actual knowledge of how an erroneous item was treated on the return is not relevant to the determination of his actual knowledge of the item.

Example 3: E and F filed jointly. In 1999, E signed a blank return; F completed it and filed it without E's review. The IRS assessed a deficiency for 1999 for unreported interest income attributable to F. E knew of the interest income, and so will not qualify for relief; his lack of return review is irrelevant. E would also not qualify for relief if he had reviewed the completed return, but had not noticed that the income was omitted. However, E would qualify for relief if (1) F received interest and dividend income from the same source, (2) properly reported the interest income, but (3) omitted the dividend income and (4) E knew that F received interest and dividend income, but did not know the total amount. Although interest and dividend income are required to be separately stated on a couple's tax return, they are one item for Sec. 6015 purposes, because they were received from the same source. E did not have actual knowledge that the item (the combined interest and dividend income) was greater than the reported amount.

Knowledge of proper tax treatment irrelevant: Actual knowledge of the proper treatment of an item is irrelevant to the determination of actual knowledge and insufficient to meet the no-knowledge requirement.

Example 4: G and H filed jointly and reported G's self-employment (SE) income, but not SE tax. H knew of G's SE income, but did not know about SE tax. The IRS assessed a deficiency for the unpaid SE tax. H does not qualify for relief, because he had actual knowledge of G's SE income.

Example 5: J and K filed jointly. Although J knew that K owned a business, no Schedule C was attached to the return. The IRS assessed a deficiency for $50,000 of unreported business income.

Variation 1—If J did not know whether K received income from the business, J qualifies for relief from the $50,000 deficiency (no knowledge of the unreported income).

Variation 2—If J knew that K had received $30,000 income, but did not know of the remaining $20,000, J qualifies for relief from the $20,000 deficiency balance (no knowledge).

Variation 3—If J did not know the exact income K received, but knew that K received at least $15,000, J will qualify for relief from the $35,000 deficiency balance (no knowledge).

Variation 4—If K had reported $45,000 business income, but had omitted $5,000, and J did not know that K had earned more than $45,000, J qualifies for relief from the $5,000 deficiency balance (no knowledge).

Variation 5—If K had reported $38,000 of income, omitting $12,000, and J knew that K earned at least $45,000, J qualifies for relief from the $5,000 deficiency balance (no knowledge).

Example 6: L and M filed a joint return in which M claimed a $2,000 charitable deduction. The IRS assessed a deficiency on that item.

Variation 1—If L knew that M had not made a charitable contribution, L would not qualify for relief (actual knowledge).

Variation 2—If L did not know whether M had made a charitable contribution, L would qualify for relief (no knowledge).

Variation 3—If L knew that M had made a charitable contribution, but had no knowledge of the amount and the IRS disallowed $500 of the deduction, L would qualify for relief from the resulting liability (no knowledge of the contribution amount).

Knowledge of source of erroneous item: Knowledge of the source of or reason to know of an erroneous item is insufficient to establish actual knowledge. Actual knowledge may not be inferred from an RS's reason to know.

Example 7: N and O filed jointly. N knew that O owned stock, but did not know that it paid dividends. The IRS assessed a deficiency for unreported dividends. N qualifies for relief, because his knowledge of O's stock ownership is insufficient to establish actual knowledge of O's dividend income. Further, N knew that O gambled and kept a separate bank account for the gambling funds, but did not know the amounts deposited or withdrawn and whether O won or lost. If the IRS assesses a deficiency for unreported gambling winnings, N qualifies for relief (no actual knowledge). The IRS cannot infer actual knowledge from N's reason to know of the income.

All facts and circumstances considered: To establish that an RS had actual knowledge of an erroneous item when the return was signed, the Secretary can rely on all of the facts and circumstances, including whether the RS made a deliberate effort to avoid learning about the item or was a joint owner, with the NS, of the property that produced the erroneous item. An RS living in a community property state when the return was signed will have an ownership interest in an item only if his name appeared on the ownership documents or there is an indication that he had a direct interest in the item.

Example 8: P and Q live in a community property state; thus, P is deemed to own one-half of the bonds that Q purchased after their marriage. Because the bonds are not held in P's name and there is no indication that P has a direct interest in them, P does not have an ownership interest in them.

Relief Exceptions

Prop. Regs. Sec. 1.6015-1(a)–(e) and (h) provide that JSL relief is not available for:

Taxes reported on a Federal joint return that are not income taxes imposed under the Code's Subtitle A (e.g., Sec. 3510 domestic service employment taxes). Relief is available for Federal income and SE taxes (including penalties, additions to tax and interest).
Joint returns signed under duress. Prop. Regs. Sec. 1.6013-4(d) provides that a return signed under legal duress is not a joint return; thus, a taxpayer who signed a return under duress is not jointly and severally liable for the return's tax or tax deficiency. The tax on the return must be adjusted to reflect only the tax (calculated using married filing separately rates) attributable to the individual who voluntarily signed the return (i.e., the NS).
Any tax year for which the RS entered into (1) a closing agreement (other than an agreement under Sec. 6224(c)) to eliminate the same liability or (2) an offer in compromise.
Situations in which one spouse transferred assets to the other as part of a fraudulent scheme.
Any tax year for which a court has rendered a final determination on the RS's tax liability, if that spouse materially participated in the proceeding, unless, due to the Sec. 6015 effective date, relief was not available in that proceeding.
Taxes attributable to state or Federal transferee liability (Secs. 6901–6904) or property laws.

Example 9: R and S filed jointly. S died; his executor transfers all estate assets to R. The joint return is audited and the deficiency is attributed to S. Although R is relieved of liability under Sec. 6015 and S's estate is solely liable for the deficiency, the deficiency may be collected from R to the extent permitted under Federal or state transferee liability or property laws.

Election and Request Procedures

How

To elect innocent spouse relief or a deficiency allocation or request equitable relief, Prop. Regs. Sec. 1.6015-5 requires that an RS must (1) file Form 8857; (2) submit a written statement containing the information required on Form 8857 and signed under penalties of perjury; or (3) submit information specified in IRS guidance.

To protect domestic violence victims who apply for innocent spouse relief, IR 2001-13⁴ requests taxpayers to write "Potential Domestic Abuse Case" at the top of Form 8857 and explain their concerns in a statement attached to the claim.

When

The information must be filed with the IRS no later than two years from the date of the first collection activity against the RS after July 22, 1998 (as was discussed, Sec. 6015 is effective for tax liabilities arising or remaining unpaid after this date).

Example 10: To collect a joint tax liability, a levy is made on T's bank on Jan. 10, 1998. The levy only partially satisfies the liability, but the IRS takes no other collection measures. T elects relief from the unpaid liability on Jan. 2, 2001. Because the IRS has not taken any collection measures after July 22, 1998, the two-year period has not begun and the election is timely. If, however, a second levy was made on July 23, 1998, T's election is not valid, because it was filed more than two years after the first collection activity after July 22, 1998.

An election or relief request can be made before collection activity has begun. Prop. Regs. Sec. 1.6015-5(b)(3) permits early requests if made (1) in connection with an audit or examination of the joint return or (2) under Sec. 6320 or 6330 pre-levy collection due process hearing procedures. However, a premature claim is not a relief election or request and will not be considered by the IRS. A premature claim is a claim for relief filed for a tax year before the taxpayer receives an audit notification, letter or notice (other than a Sec. 6223 Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership proceedings notice) that there may be outstanding tax liability for that year.

"Collection Activity" Defined

Prop. Regs. Sec. 1.6015-5(b)(2) defines collection activity as (1) a Sec. 6331 administrative "levy" or seizure to obtain "property of the RS"; (2) a Sec. 6402 offset of an overpayment of the RS against a liability; (3) the filing of a suit by the U.S. against an RS for collection of a joint liability; or (4) the filing of a claim by the U.S. in a court proceeding in which an RS is a party (or which involves an RS's property). Collection activity does not include (1) a Sec. 6330 or 6331(d) notice of intent to levy, (2) the filing of a notice of Federal tax lien or (3) a demand for payment of tax.

If tangible personal or real property is seized and to be sold, the date of levy and seizure is the date the notice of seizure is given. If a levy is made on cash or intangible personal property that will not be sold, the date of levy or seizure is the date the notice of levy is made. If the notice of levy is served by mail, the date of levy or seizure is the date the notice of levy is delivered to the person on whom made.

Example 11: A notice of intent to levy is mailed to U and V on Feb. 9, 2001. On May 10, 2001, a levy on U's wages is delivered to U's employer; on June 18, 2001, a levy on V's wages is delivered to V's employer. U must elect or request relief by May 10, 2003, and V must elect or request relief by June 18, 2003, two years after the levy is delivered to the employers.

Example 12: W and X do not pay the tax due on their timely filed joint return. No effort is made to collect the tax until a suit is filed by the IRS on July 23, 2000 to reduce the tax assessment to judgment and foreclose the tax lien on their jointly owned home. W elects relief on Jan. 10, 2001. The election is valid because it is made within two years of the date the collection suit was filed against W.

Example 13: Y files a Chapter 7 bankruptcy petition on Sept. 8, 2001. On Oct. 28, 2001, the IRS files a proof of claim for a joint tax liability. Y elects relief on Aug. 18, 2002. The election is valid because it is made within two years of the date the IRS filed a claim in Y's bankruptcy case.

Relief Determination Limit

An RS can obtain only one final administrative determination of relief for a given assessment, unless a second relief election is made. A second relief election can be made if a deficiency allocation election was made, for which the RS did not qualify when it was made, but did qualify at the time of the second election.

Example 14: A owns 10,000 shares of stock and also invests in a partnership tax shelter. A and B filed a joint return reporting A's tax shelter losses, but (unknown to B) omitting A's dividend income. In 2003, the IRS begins a TEFRA partnership proceedings audit and sends A and B a Sec. 6223(a)(1) notice. Later that year, A and B are notified that their joint return will be audited for the unreported dividend income. B may file a claim for relief for the unreported dividend income, because he received notification of an audit concerning an unpaid liability on the joint return. However, he cannot file a claim for relief for the TEFRA partnership proceeding until he is sent a notice of computational adjustment or liability assessment. Because the TEFRA partnership proceeding assessment is separate from the dividend income assessment, B's relief claim for the TEFRA partnership proceeding liability cannot be denied (the dividend income relief claim had already been made).

Innocent Spouse Relief

The Sec. 6015(b) innocent spouse relief provisions are similar to the relief provisions under former Sec. 6013(e). Accordingly, the proposed regulations' preamble observes that the Sec. 6013(e) case law will be applied in interpreting Sec. 6015(b). However, Sec. 6015(b) and former Sec. 6013(e) differ in several respects. Sec. 6015(b):

Eliminates the "substantial understatement due to a grossly erroneous item" requirement.
Allows partial relief if an RS did not know (and had no reason to know) of only a portion of an understatement.
Requires the RS to elect relief.

Prop. Regs. Sec. 1.6015-2(a) provides that an RS can obtain JSL relief by meeting the above-described procedures and all of the following requirements:

1. A joint return was filed.

2. There was an "understatement" due to "erroneous items" of the NS.

3. It is "inequitable" to hold the RS liable for the deficiency due to the understatement.

4. When the return was signed, the RS did not know and had no reason to know (as discussed earlier) of the item resulting in the understatement.

"Understatement" is defined in Sec. 6662(d)(2)(A) as the tax required to be shown on the return, reduced by the excess of the tax shown on the return over any Sec. 6211(b)(2) rebates. Tax refunds are available for innocent spouse relief claims.

The IRS considers all the facts and circumstances in determining whether it is inequitable to impose JSL on an RS. Factors to be considered include whether the:

RS significantly benefited, directly or indirectly, from the understatement.
NS has not fulfilled support obligations to the RS.
Spouses have been "divorced," "legally separated" or "not members of the same household" for at least 12 months preceding the election.

Prop. Regs. Sec. 1.6015-2(d) defines a significant benefit as any benefit in excess of normal support. A direct or indirect benefit includes transfers of property or rights to property, even if received several years after the understatement. For example, an RS will have received a significant benefit if he received property (including life insurance proceeds) from the NS traceable to items attributable to the NS and omitted from gross income.

Rev. Proc. 2000-15 describes additional factors to be used in determining inequity, including whether the:

RS would suffer economic hardship if relief was not granted.
RS was abused (but not put under duress) by the NS.
Liability is solely attributable to the NS.

Rev. Proc 2000-15 identifies an RS's lack of a good-faith effort to comply with the Federal income tax laws for the relief year or any subsequent year as a factor weighing against relief.

Deficiency Allocation

The deficiency-allocation category allows an estranged or former spouse to limit a deficiency liability to the portion allocable to him. Relief under this election does not require a determination of inequity. Under Prop. Regs. Sec. 1.6015-3(a) and (c)(2), an RS may elect to allocate a deficiency if he is (1) divorced, widowed, legally separated or has not been a member of the NS's household at any time during the 12-month period ending on the date the relief election is filed; and (2) had no actual knowledge (as discussed earlier), at the time the return was signed, of an erroneous item allocable to the NS.

The election applies only to unpaid liabilities due to understatements; refunds are not available. The election does not relieve the RS of the allocated liability unless he qualifies for relief under the innocent spouse or equitable relief rules; it can only limit the RS's liability to the allocated deficiency. The NS remains liable for the entire unpaid amount of the deficiency, unless the NS also files a deficiency-allocation election or obtains innocent spouse or equitable relief. If both spouses elect to allocate the deficiency, part of the deficiency may not be allocable; both spouses would remain jointly and severally liable for that portion of the deficiency. Under the Prop. Regs. Sec. 1.6015-3(d)(3) burden-of-proof rule, the RS must (1) establish the proper allocation of erroneous items and (2) prove that all of the qualifications (except for actual knowledge) for making the election are met and none of the limits (such as the transfer of disqualified assets) apply.

Divorced/Legally Separated/Different Household

An RS is "divorced" under Prop. Regs. Sec. 1.6015-3(b)(1) if he has a divorce decree recognized in the jurisdiction in which he resides. A spouse is legally separated under Prop. Regs. Sec. 1.6015-3(b)(2) if the separation is recognized under the laws of the jurisdiction in which he resides. Spouses are members of the same household if they live in the same dwelling. Spouses temporarily absent from the household are members of the same household, under Prop. Regs. Sec. 1.6015-3(b)(3), if (1) it is reasonable to assume that the absent spouse will return to the household and (2) the household (or a substantially equivalent household) is maintained in anticipation of the spouse's return. Temporary absences include, but are not limited to, absences due to incarceration, hospitalization, business or vacation travel, military service and education away from home. Spouses are not members of the same household if they live in two separate dwellings (whether or not part of the same structure), unless one spouse is temporarily absent (as defined above) from the other's household.

Computing the Allocation

Under Prop. Regs. Sec. 1.6015-3(d)(2), erroneous items are allocated between the spouses as if separate returns had been filed, with four exceptions:

1. To the extent that the RS received a tax benefit on the joint return, an erroneous item is allocated to the RS.

2. The IRS may allocate any item between spouses if it establishes that it is appropriate due to fraud by one or both of the spouses.

3. Erroneous income items are allocated to the spouse who was the source of the income. Wage income is allocated to the spouse whose work produced the income; business or investment income is allocated to the spouse-owner. An asset jointly owned is allocated 50% to each spouse, unless there is clear and convincing evidence supporting a different allocation. Community property income is not allocated to a spouse solely based on community property laws. The income is allocated if the spouse's name appeared on ownership documents or there is an indication that the spouse had a direct interest in the item.

4. Erroneous deduction items are allocated as follows: Business or investment items are allocated to the spouse-owner. Items attributable to a jointly owned business or investment are allocated in proportion to each spouse's ownership interest; if there is no clear and convincing evidence supporting a different allocation, the item is allocated 50% to each spouse. Personal deduction items are allocated 50% to each spouse, unless the evidence shows a different allocation is appropriate.

Example 15: C and D filed jointly. After their divorce, they received an IRS deficiency notice attributable to (1) unreported interest income from their joint bank account (D had actual knowledge of the interest), (2) C's disallowed business deductions and (3) a disallowed Lifetime Learning credit for D's education. D elects to allocate the deficiency. Although one-half of the interest income would be allocated to each spouse, the election cannot be made for the interest, because D had knowledge of the income. Thus, C and D remain jointly and severally liable for the interest. The business expense deduction is allocated to C; the Lifetime Learning credit is allocated to D.

Allocation Methods

According to Prop. Regs. Sec. 1.6015-3(d)(4)(i)(B), the proportionate allocation method applies to any portion of the deficiency, other than any portion:

Attributable to erroneous items allocable to the NS of which the RS had actual knowledge (the RS remains liable for these items).
Attributable to "separate treatment items" (STIs).
Related to the liability of a child of the RS or NS.
Attributable to special items (such as the AMT or accuracy-related or fraud penalties).
Allocable according to alternative allocation methods.

Proportionate allocation: Under Prop. Regs. Sec. 1.6015-3(d)(4)(i)(A), the portion allocable to a spouse is an amount that bears the same ratio to the deficiency as the net amount of the erroneous items allocable to the spouse bears to the net amount of all erroneous items.

Example 16: E and F filed jointly. After their divorce, they received a $36,000 IRS deficiency notice, attributable to $100,000 of the following erroneous items: (1) $30,000 of E's unreported income; (2) $10,000 of E's disallowed business deductions; (3) $20,000 of E's disallowed interest expense deductions; (4) $25,000 of F's unreported income; and (5) $15,000 of F's disallowed charitable deduction. E elects deficiency allocation. Because 60% ($60,000/$100,000) of the erroneous items are attributable to E and 40% to F, E's liability for the deficiency is limited to $21,600 (60% x $36,000 deficiency). Thus, the IRS may collect up to $21,600 from E and up to $36,000 (the entire amount of the deficiency, less any amount collected from E) from F. If F also elects deficiency allocation, $21,600 could be collected from E and $14,400 (40% x $36,000 deficiency) from F.

Example 17: G and H filed jointly. After their divorce, they received an $18,000 IRS deficiency notice, attributable to $50,000 of the following erroneous items: (1) $10,000 of unreported dividends from jointly held stock (of which both had knowledge); (2) $25,000 of G's unreported income; and (3) $15,000 of H's disallowed business deductions. G elects deficiency allocation. G cannot allocate and has JSL for the $3,600 (($10,000/$50,000) x $18,000) deficiency attributable to the unreported dividends, because G had knowledge of that item. The remaining $14,400 deficiency ($18,000 – $3,600) is allocated between G and H, based on the ratio of the remaining erroneous items ($25,000 of the remaining $40,000 is allocated to G and $15,000 is allocated to H). G's allocated deficiency is $9,000 (($25,000/$40,000) x $14,400). Thus, the IRS can collect up to $12,600 ($3,600 deficiency from dividends + $9,000 allocated deficiency) from G and up to $18,000 (entire deficiency) from H. If H also elects deficiency allocation, he is liable for $9,000 of the deficiency ($3,600 deficiency from dividends + $5,400 (($15,000/$40,000) x $14,400) of the deficiency attributable to him).

Example 18: J and K filed a joint return on which J reported $60,000 wage income and K reported a $10,000 business loss ($5,000 revenue – $15,000 deductions). After their divorce, they received a $4,500 IRS deficiency notice in which all of K's business expense deductions were disallowed. J had no knowledge of the deductions and elects deficiency allocation. K received a benefit from only $5,000 of the disallowed deductions (the actual revenue). The $10,000 remaining disallowed deductions reduced the wage income J reported on the joint return. Thus, of the $15,000 of disallowed deductions, $5,000 is allocated to K; the remaining $10,000 is allocated to J. Thus, J's liability for the deficiency is limited to $3,000 (($10,000/$15,000) x $4,500). K cannot elect deficiency allocation, because he knew of the erroneous deductions. If, however, only $12,000 of K's deductions had been disallowed, he would have received a benefit from the $3,000 allowed deductions and $2,000 of the disallowed deductions. Thus, $2,000 of the disallowed deductions would be allocated to K and the remaining $10,000 to J. J's liability for the deficiency would be limited to $3,750 (($10,000/$12,000) x $4,500).

STI allocation: Under Prop. Regs. Sec. 1.6015-3(d)(4)(ii), STIs are items that are allocable only to one spouse and result from the disallowance of a credit, tax or addition to tax (other than the Sec. 1 regular income tax or the Sec. 55 AMT) required to be included on a joint return. The deficiency attributable to STIs is added to the RS's share of the deficiency after the proportionate allocation.

Example 19: L and M filed jointly. After their divorce, they received a $27,000 IRS deficiency notice attributable to $5,000 of L's disallowed interest expense deduction, $1,000 of L's Lifetime Learning credit, $45,000 of M's unreported income and $7,000 of M's unreported SE tax. L and M both elect deficiency allocation. The STIs, consisting of the $1,000 Lifetime Learning credit and the $7,000 SE, are not subject to proportionate allocation. Thus, only $19,000 ($27,000 – $8,000 STIs) of the deficiency can be allocated proportionately. For the deficiency attributable to the $50,000 proportionate allocation items ($5,000 of disallowed interest + $45,000 of unreported income), $1,900 (($5,000/$50,000) x $19,000) will be allocated to L and $17,100 to M. After the proportionate allocation is completed, the STI amount is added to each spouse's allocated share of the deficiency. Thus, L's liability is limited to $2,900 ($1,900 + $1,000); M's liability is limited to $24,100 ($17,100 + $7,000).

Allocating a child's liability: The portion of a deficiency relating to the liability of an RS's or NS's child is allocated jointly to both spouses, under Prop. Regs. Sec. 1.6015-3(d)(4)(iii). If one spouse had sole custody of the child for the entire year for which the deficiency allocation is to be made, the child's liability is allocated solely to that spouse. Because a child does not include a stepchild unless legally adopted by the taxpayer, a stepchild's liability is allocated solely to the parent spouse.

Allocating special items: Prop. Regs. Sec. 1.6015-3(d)(4)(iv) provides that the portion of a deficiency attributable to a Sec. 6662 accuracy-related or Sec. 6663 fraud penalty is allocated to the spouse whose item resulted in the penalty. A deficiency attributable to the Sec. 55 AMT is allocated between spouses in the same proportion as each spouse's share of the total Sec. 55(b)(2) alternative minimum taxable income (AMTI).

Example 20: N and O filed jointly. After their divorce, they received a IRS $4,000 deficiency notice, attributable to unreported AMT. Their $100,000 AMTI was $20,000 attributable to N and $80,000 to O. N elects deficiency allocation. His liability is limited to $800 (($20,000/$100,000) x $4,000). O is liable for the entire $4,000 deficiency (less the amount paid by N), because O did not elect to allocate.

Alternative allocation methods: If a deficiency arises from items subject to different tax rates (e.g., ordinary income and capital gains), the erroneous items are first separated into categories according to their applicable tax rate. A separate allocation is then made for each rate category, using the proportionate allocation method. In addition, Prop. Regs. Sec. 1.6015-3(d)(6) provides that Treasury may prescribe other allocation methods.

Example 21: P and Q filed jointly. After their divorce, they received a $6,600 IRS deficiency notice, attributable to P's $10,000 unreported ordinary income, P's $5,000 unreported capital gain and Q's $10,000 unreported capital gain. Both elect deficiency allocation. A 36% marginal rate applies to the $10,000 of ordinary income; a 20% rate applies to the $15,000 of capital gains. Thus, $3,000 ($15,000 x 20%) of the deficiency is attributable to the unreported capital gains and $3,600 ($10,000 x 36%) is attributable to the ordinary income. The three erroneous items are categorized by tax rate and the deficiency is then allocated among them. Of the $15,000 of 20% items, $1,000 ($5,000 x 20%) of the deficiency is attributable to P and $2,000 ($10,000 x 20%) is attributable to Q. The $3,600 deficiency attributable to the ordinary income is allocated to P. Thus, P is liable for $4,600 ($1,000 + $3,600) of the deficiency; Q is liable for $2,000 of the deficiency.

Disqualified Assets

Under Prop. Regs. Sec. 1.6015-3(c)(3)(ii), if an RS (1) receives property or the right to property from the NS and (2) the principal purpose of the transfer was to avoid tax or the payment of tax (including additions to tax, penalties and interest), such property is a "disqualified asset." A disqualified asset increases (up to the entire amount of the deficiency) the portion of the deficiency allocable to the RS by the fair market value (on the date of transfer) of that property. Under Prop. Regs. Sec. 1.6015-3(c)(3)(iii), an asset transferred (1) during the 12-month period before or (2) on any day after the mailing date of the first letter of proposed deficiency (i.e., a 30-day letter or deficiency notice) is presumed to be a disqualified asset. This presumption does not apply if the RS can establish that (1) the asset was transferred via a divorce decree or separate maintenance agreement or (2) the principal purpose of the transfer was not to avoid tax or the payment of tax.

Example 22: After R and S filed a 1998 joint return, they divorced. In May 2000, a $50,000 IRS deficiency notice is mailed to them. In July 2000, S transfers $10,000 to R. R elects deficiency allocation and proposes that $20,000 ($50,000 x 40%) of the deficiency be allocated to R and $30,000 ($50,000 x 60%) be allocated to S. R also submits a statement that the principal purpose of the $10,000 transfer was not avoidance of tax or payment, but does not submit any documentation indicating the reason for the transfer; this does not overcome the presumption that the $10,000 is a disqualified asset. Thus, R is liable for $30,000 of the deficiency ($20,000 portion of the deficiency for which R is liable + $10,000 value of the disqualified asset), unless R qualifies for relief under one of the other categories. If the $10,000 transfer from R to S was pursuant to the divorce decree, the transfer is not presumed to be of a disqualified asset, even though it occurred after the deficiency notice was mailed.

Equitable Relief

The legislative history of the IRSRRA '98 states that equitable relief is granted when:

1. A tax liability properly reported on a return was not paid and the RS had no reason to know (and did not know) that the funds used to pay the tax were taken by the NS and used for his benefit.

2. The IRS, considering all of the facts and circumstances, determines it would be inequitable to hold the RS jointly and severally liable for an unpaid tax or deficiency.⁵

Prop. Regs. Sec. 1.6015-4(c) states that the criteria used in this determination will be provided in published guidance. According to Rev. Proc. 2000-15, a request for equitable relief can be made by an RS who filed a joint return, for which a liability remains unpaid (a refund of a tax already paid cannot be obtained), and who does not qualify for full relief under the innocent spouse or the deficiency-allocation provisions.

Rev. Proc. 2000-15 also lists the following additional general conditions for equitable relief:

1. No assets were transferred between the spouses filing the joint return as part of a fraudulent scheme.

2. If disqualified assets were transferred to the RS by the NS, relief will be available only to the extent that the unpaid tax liability exceeds the disqualified assets' value.

3. The RS did not file the return with fraudulent intent.

Equitable relief will ordinarily be granted when a joint return liability is unpaid and all of the following requirements are met: (1) at the time relief is requested, the RS is no longer married to, is legally separated from the NS or has not been a member of the same household at any time during the 12-month period ending on the date the relief was requested; (2) at the time the return was signed, the knowledge requirement discussed earlier was met; and (3) the RS will suffer economic hardship if relief is not granted.

However, relief is subject to limits. If a return is or has been adjusted to reflect a tax understatement, relief is available only to the extent of the liability prior to the adjustment. Further, relief is available only to the extent of the unpaid liability allocable to the NS.

Factors to be used in determining whether it would be inequitable to impose JSL on the RS include (1) whether the RS had reason to know or knew of the item that produced the deficiency or that the reported liability would not be paid; (2) the existence of economic hardship or abuse; and (3) a liability solely attributable to the NS.

Administrative Proceedings

To protect NSs from erroneously granting relief to RSs, the proposed regulations provide safeguards to balance the rights and interests of both parties. Although a spouse is liable for the entire tax liability on a joint return, the determination that the RS is relieved of JSL may affect the NS, because the IRS's only recourse would then be to collect the liability from the NS.

Prop. Regs. Sec. 1.6015-6 provides that, on receipt of an innocent spouse or deficiency-allocation election or a request for equitable relief, the Secretary must inform the NS of the request and allow him to submit information to be considered in the determination. Failure to submit such information does not affect an NS's ability to seek relief for the same year. However, if the NS also submits an application for relief, the information so submitted will be used to determine whether relief is also appropriate for that spouse. All information submitted by the NS will be considered in determining whether relief is appropriate and should include:

The marriage's legal status.
The extent of the RS's knowledge of the erroneous items or underpayment.
The extent of the RS's knowledge or participation in the family business or financial affairs.
The RS's education level.
The extent to which the RS benefited from erroneous items.
Any asset transfers between the spouses.
Any indication of fraud by either spouse.
Whether it would be inequitable to hold the RS jointly and severally liable for the liability.
The allocation or ownership of items giving rise to the deficiency.
Anything else relevant to the determination of whether relief should be granted.

The Secretary may share any information provided by one spouse with the other. However, a spouse may request that the shared information not contain his name, address, employer, telephone number and any other information that would indicate his location.

The Secretary must notify the NS of the government's decision as to whether the RS's request for relief was granted; an NS cannot appeal the decision.

Tax Court Review

Under Prop. Regs. Sec. 1.6015-7, RSs may petition the Tax Court to review a denial of JSL relief. The petition must be made within the 90-day period beginning on the date the final determination letter is mailed. If the final determination letter is not mailed within six months of the date the innocent spouse or deficiency-allocation election is made, the petition may be made at any time after the six-month period has expired and before the expiration of the 90-day period beginning on the mailing date of the final determination letter.

Unless it is determined that collection will be jeopardized by delay, no levy or proceeding in court will be made, begun or prosecuted against an RS (who elects innocent spouse relief or deficiency allocation) for the collection of an assessment to which the election relates until the expiration of the 90-day period described above or, if a petition is filed with the Tax Court, until its decision becomes final. If the RS appeals the Tax Court decision, the IRS may resume collection of the liability from the RS on the date of the Tax Court's determination, unless the RS files an appeal bond. These restrictions on collection do not apply to spouses requesting only equitable relief.

The running of the Sec. 6502 statute of limitations on collection against the RS of an assessment (subject to an innocent spouse or deficiency-allocation election) is suspended for the period during which the IRS is prohibited from collecting by levy or a proceeding in court and for 60 days thereafter. The suspension of this period does not apply to spouses requesting only equitable relief.

Conclusion

Since the 1998 enactment of the Sec. 6015 JSL relief rules, the number of cases received by the IRS has increased from 3,000 to 5,000 new cases per month. This dramatic increase in innocent spouse relief underscores the need for guidance that explains and clarifies Sec. 6015's complex rules. The proposed regulations fill this need by providing many useful definitions and examples that will enable tax advisers to help their clients obtain relief.