Gerald W. Kelly
Article: Copyright © 2006
Will the IRS believe that you are an Innocent Spouse?
If a joint income tax return is audited, the IRS will seek to hold each spouse responsible for any additional tax due. The IRS recognizes, however, that there are situations where one spouse should not be required to pay a tax debt caused by a current or former spouse.
Read the story of a hypothetical couple…
By signing a joint tax return, each spouse is representing to the IRS, under penalties of perjury, that the reported income and deductions are correct. In many cases, one spouse might rely completely on the other spouse to provide accurate information. This is especially true in situations where one spouse operates a business completely independent of the other spouse.
A successful innocent spouse claim eliminates the joint tax debt caused by the "guilty" spouse. Petitioning the IRS for innocent spouse relief is not a simple matter. To start with, there are three types of relief: traditional, separation of liability, and equitable. Each has different legal and factual requirements that must be satisfied. A hypothetical couple will provide us with an overview of each type of relief and also illustrate frequently encountered issues and pitfalls. Dr. Dane Bramage is a world-renowned neurologist. He operates a well-established and profitable medical practice. Mrs. Bramage is a successful writer and has no involvement whatsoever in the financial affairs or operations of her husband’s practice. The Bramages have filed joint tax returns since they were married twenty years ago.
After receiving an anonymous tip, the IRS initiates a comprehensive audit of Dr. Bramage’s corporate and individual tax returns. Dr. Bramage keeps the audit a secret from his wife, as he doesn’t want her to worry. He also doesn’t want her to know that he claimed a condominium, convertible, and other payments to his mistress as business expenses, substantially reducing his net income for the tax year under audit. When the smoke clears and the audit is completed, a notice is issued advising that the IRS intends to make additional tax assessments totaling $800,000. Since they filed a joint tax return, Dr. and Mrs. Bramage will be jointly and
severally liable for the entire $800,000. The additional tax assessment is based on income that Dr. Bramage failed to report and his improper business deductions. The IRS did not question the income and expenses associated with Mrs. Bramage's writing assignments. After receiving the notice of proposed assessment from the IRS, Dr. Bramage makes a full disclosure to Mrs. Bramage.
In order for Mrs. Bramage to be successful in obtaining traditional innocent spouse relief – the first of the three types – she must establish that at the time she signed the tax return, she did not know or did not have a reason to know that additional taxes were due. Clearly, Mrs. Bramage had no actual knowledge. She relied on the financial and tax information provided by her husband. Notwithstanding, the IRS could argue that she had a reason to know, or constructive knowledge, of the understatement of tax. The
sharp drop in income from Dr. Bramage’s medical practice could impose a duty on Mrs. Bramage to make additional inquiries before signing the return.
In addition to a lack of actual or constructive knowledge, Mrs. Bramage must also demonstrate that it would be unfair to hold her responsible for the tax liability caused by her husband’s omissions. One of the key factors the IRS considers is whether Mrs. Bramage received a “significant benefit” from the income Dr. Bramage failed to report. Mrs. Bramage’s earnings as a writer weigh heavily in her favor, as she had a means of support other than her husband's income. However, if Mrs. Bramage had been a stay-at-home mom raising the couple’s four children, the IRS might take the position that she did, in fact, benefit financially from her husband’s actions.
Generally speaking, separation of liability, the second of the three types, is the easiest form of relief to obtain. Here, the requesting spouse is making an election to pay tax on only their earnings, similar to the retroactive filing of a separate return. There should not be an inquiry by the IRS into the issues of fairness and constructive knowledge. Unlike traditional innocent spouse relief described above; however, Mrs. Bramage would be required to leave her husband in order to qualify.
Separation of liability is available only for spouses that are legally separated, divorced, widowed, or those that have been estranged and living apart for twelve months.
With this type of relief, the tax obligation of each spouse is allocated based on each spouse’s income. Mrs. Bramage, therefore, would still be responsible for paying the tax associated with her writing activity. She would be relieved of any additional tax connected to Dr. Bramage’s medical practice.
A new hypothetical must be used to illustrate the third type of innocent spouse relief, equitable relief. Assume that on April 15, Dr. Bramage presents Mrs. Bramage with a tax return showing tax due of $800,000. Dr.
Bramage asks her to sign it, shows her a cashier’s check for $800,000 payable to the IRS, and promises it will be sent with the return. It turns out that Dr. Bramage had forged the cashier’s check for the purpose of enticing his wife to sign the joint return. He knew that the IRS would collect the tax from her assets and income. Dr. Bramage then leaves his wife, his failing medical practice, and the United States. The IRS promptly initiates collection action against Mrs. Bramage. Since she signed a tax return indicating that tax was due, Mrs. Bramage is not eligible for traditional or separation of
liability relief, as they apply only to tax assessments made following an audit. Here, Mrs. Bramage knew at the time she signed the return that a debt was owed to the IRS.
In evaluating Mrs. Bramage's equitable relief claim, the IRS will look closely at all of the facts and circumstances to determine if it would be fair to compel her to pay the entire tax debt. An important consideration would be the economic hardship created by collecting the full tax, penalties and interest. The critical question would be whether Mrs. Bramage could still meet her necessary living expenses, as defined by the IRS, and satisfy the joint tax obligation. Given her husband's actions, Mrs. Bramage would have a persuasive argument that she shouldn't be required to pay, but equitable relief is extremely difficult to obtain unless the requesting spouse is nearly destitute.
Other important issues that can arise in innocent spouse cases include:
Refunds of taxes already paid
The input of the "guilty" spouse, which is solicited by the IRS
The timing of the claim
Transfers of assets, and
Cases involving domestic violence.
While a successful innocent spouse petition requires a careful evaluation of the facts and applicable law, it offers hope for spouses bearing the burden of a tax liability that they did not cause.
Gerald W. Kelly, Esq.
Article: Copyright © 2006-19