Editor: Albert B. Ellentuck, Esq.
Married taxpayers filing a joint income tax return have joint and several liability for the tax, and the IRS will look to both taxpayers for payment. However, Sec. 6015 provides two potential sources of relief to spouses and former spouses facing joint and several liability problems. Also, a third escape hatch for overall “equitable relief” is also provided if, considering all the facts and circumstances, it is inequitable to hold a taxpayer liable for any unpaid tax or deficiency. The innocent-spouse provisions apply only to taxes imposed by subtitle A of the Code, which generally includes income tax, the alternative minimum tax, self-employment taxes, and presumably the 3.8% net investment income tax, plus any related interest or penalties (Regs. Sec. 1.6015-1(a)(3)). Payroll taxes on household employees are not subject to the relief provisions.
The rules are found in Sec. 6015. Sec. 6015(b) provides a general relief rule available to all joint filers, including those who are still married. This is commonly referred to as traditional relief. The second form of relief is provided by Sec. 6015(c), which is available to joint filers who, at the time an election is filed, are divorced or legally separated from the other party to the joint return in question or have lived apart from the other party for the preceding 12 months. This is sometimes referred to as the separate liability election. To benefit from either provision, the taxpayer wanting relief (the electing individual) must make an election within two years of the commencement of IRS collection activity. The election is made by timely filing Form 8857, Request for Innocent Spouse Relief.
Traditional Relief for an Innocent Spouse
The general relief rule under Sec. 6015(b) is available to electing joint filers when there is a tax understatement attributable to erroneous items of the other party if the electing individual establishes that he or she did not know of the understatement and had no reason to know of the understatement. The general test of whether a spouse had actual knowledge or reason to know of the understatement is whether the spouse directly participated in the understatement or whether a reasonable person in the spouse’s circumstances when the return was filed could be expected to know of the understatement (Shea, 780 F.2d 561 (6th Cir. 1986)). In addition, it must be shown that it would be inequitable to hold the electing individual responsible for the understatement after considering all the facts and circumstances (Sec. 6015(b)(1)(D)).
Although courts do not agree, the extent of the duty to investigate a transaction has been analyzed by reference to standards virtually identical to those discussed in regard to the granting of equitable relief and whether it would be fair to hold the alleged innocent spouse liable. Some of these factors include:
- Changes in standards of living or levels of income as a result of the transaction in question;
- The sophistication, education, and level of experience of the spouse seeking relief;
- The involvement of the allegedly innocent spouse in the business or financial affairs of the family; and
- The degree to which the other spouse has been evasive or deceitful about finances or the transaction.
The general relief rule under Sec. 6015(b) can also extend to what might be called semi-innocent individuals (those who have some knowledge of an understatement as long as they did not know and had no reason to know the full extent of the understatement). In this case, a semi-innocent joint filer can make the Sec. 6015(b) election and receive relief for the unknown portion of the tax understatement caused by the other party (Sec. 6015(b)(2)).
Separate Liability Election
Under the Sec. 6015(c) election, the liability of the electing individual for a joint return understatement cannot exceed the amount determined to be the separate liability of that person. In essence, the separate liability of each joint filer is determined by allocating income and deduction amounts as if separate returns were filed (but without considering any of the deduction or credit disallowances that would apply if separate returns were actually filed) (Sec. 6015(d)).
However, this election does not apply to tax understatements (or portions thereof) caused by the other party about which the electing individual had actual knowledge at the time of signing the joint return (Sec. 6015(c)(3)). Such understatements remain subject to the joint and several liability rule. The IRS has the burden of proving the taxpayer had such knowledge. And, as mentioned previously, the election is available only if, when the election is filed, the spouses are divorced or legally separated or are not members of the same household at any time during the preceding 12 months.
Regs. Sec. 1.6015-3 provides insight into relevant phrases such as “not members of the same household” and “actual knowledge” of the erroneous item, which the regulation discusses at some length. Such knowledge means knowledge of the receipt or expenditure, not the proper tax treatment of the item or whether it was reported on the return. A spouse could have actual knowledge of an item without necessarily knowing its source. Joint ownership of property that is the source of the item is specifically discussed as indicative of knowledge of the item.
Generally, income and deductions for this purpose are allocated to the spouse who is the source of the particular item. Therefore, earned income is allocated to the spouse who earned the income; investment income is allocated in proportion to title ownership of the asset generating the income; personal deductions are allocated equally unless proven to be paid from one party’s assets; income taxes withheld are allocated to the spouse from whose income they were withheld; and estimated tax payments are allocated to the spouse who paid them (or split equally if payments were made jointly). See Chief Counsel Notice N(35)000-170 for further instructions on these allocation rules.
Sec. 6015(c)(4) provides that the electing spouse’s portion of any deficiency is increased by the value of any disqualified assets, which are assets transferred to the electing spouse by the other spouse with the principal purpose of avoiding tax. If the property was transferred other than by a divorce instrument and was made within one year prior to when the IRS sent its first notice of proposed deficiency, there is a rebuttable presumption that the transfer was made to avoid tax.
Planning tip: The Sec. 6015(b) election provides more complete liability protection, but its availability may be doubtful in many cases. Therefore, if the joint filer is divorced or separated, it appears both the Secs. 6015(b) and (c) elections should be made (Sec. 6015(a)(2) explicitly allows taxpayers to make both elections when they qualify to do so). If the Sec. 6015(b) election fails, the Sec. 6015(c) election limits the spouse’s exposure.
If relief is not available under Sec. 6015(b) or (c), Sec. 6015(f) authorizes the IRS to grant relief if, considering all the facts and circumstances, it is inequitable to hold a taxpayer liable for any unpaid tax or deficiency. Notice 2012-8 provides guidance to taxpayers seeking equitable relief under Sec. 6015(f) by providing seven threshold conditions that must be satisfied to be considered for this relief and a list of positive and negative factors to be considered in determining whether it would be inequitable to hold an individual liable for a deficiency or unpaid liability. Some of the factors to be considered are economic hardship, abuse, financial control, lack of knowledge of the deficiency, and efforts to comply with the law.
The timing for benefiting from the equitable-relief innocent-spouse provision is different from the other two innocent-spouse relief provisions. Taxpayers seeking traditional relief under Sec. 6015(b) or relief under the separate liability election of Sec. 6015(c) must make an election within two years of the commencement of IRS collection activity. However, the timing for taxpayers seeking equitable relief under Sec. 6015(f) depends on whether the taxpayer is seeking relief from a balance due or seeking a credit or refund (Notices 2011-70 and 2012-8):
- Relief from a balance due: The request for relief from a balance due must be filed within the time period the IRS has to collect the tax (i.e., 10 years from the assessment date, subject to any extensions that may have occurred).
- Seeking a credit or refund: The request generally must be filed within the later of three years after the date the original return was filed or within two years after the tax was paid (subject to special rules for taxpayers in a federally declared disaster area or physical or mental incapacity).
Innocent-spouse relief is continually evolving through the court system. The courts are constantly ruling on what does and does not constitute innocent-spouse relief. Practitioners should review relevant case law to find possible cases with similar facts to a particular client situation.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 14th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. Van Grevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Fort Worth, Texas, 2013 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.