On July 22, l998, President Clinton signed the Internal Revenue Service Restructuring and Reform Bill of 1998 (H.R. 2676) (the “l998 Act”), which significantly expands potential relief for innocent spouses from joint income tax return liabilities. The new provisions sins ate contained in new Section 6015 of the Internal Revenue Code.
Joint and several liability is the obligation imposed on married couples who chose to file joint income tax returns and benefit from the lower taxes that are imposed on such returns. Each spouse can be liable for the entire tax owed by the couple or either of them for each year in which a joint return was filed, even tax on income earned by the other spouse and omitted from the return.
Before the 1998 Act
Before the 1998 Act, a spouse who signed a joint return could sometimes be relieved of liability for unpaid taxes if the following conditions were met: (1) a joint return was filed; (2) there was a substantial understatement of tax attributable to grossly erroneous items of the other spouse on the return; (3) the innocent spouse established that, in signing the return, he or she did not know or have reason to know of the substantial understatement; and (4) under the facts and circumstances, it would be inequitable to hold the innocent spouse liable for the deficiency. Several of these conditions made qualification for innocent spouse status extremely difficult, if not almost impossible, to obtain.
A grossly erroneous item included omissions of taxable income and deductions that had no basis in law or fact. Generally, a deduction had to be frivolous, phony, or fraudulent to qualify. A deduction that was not fraudulent, but was simply questionable, did not qualify. In addition, the innocent spouse had to show that he or she did not know, and had no reason to know, about the grossly erroneous item. In other words, in the case of a deduction, the innocent spouse had to show that the deduction taken was clearly frivolous, phony, or fraudulent, while at the same time proving that he or she had no reason to suspect it was frivolous, phony, or fraudulent. An understatement of tax was not considered substantial unless it exceeded $500 and (1) exceeded 10 percent of the innocent spouse’s adjusted gross income for the year preceding the tax year in which the deficiency notice was mailed, if the innocent spouse’s income for that year was $20,000 or less; (2) exceeded 25 percent of the innocent spouse’s adjusted income for the year preceding the tax year in which the deficiency notice was mailed, if the innocent spouse’s income for that year was more than $20,000. This limitation often precluded relief for low-income taxpayers, even though they were often the hardest hit.
The 1998 Act provides partial relief where spouses are partially innocent The IRS applied the “reason to know” test very strin-gently, particularly when the deficiency for which innocence was sought was derived from a deduction that showed up on the face of a return. The IRS imposed an obligation on each spouse to thoroughly review a return before signing it and it felt that few spouses did not have reason to know of the erroneous deduction when it was there for the naked eye to see.
The courts varied greatly in their application of this test. Some felt that the existence of the deduction on the face of the return, or knowledge of the facts of the transaction that generated the deduction, imputed “reason to know” to the innocent spouse. Other courts focused on the innocent spouse’s educational level, business acumen, and simi-lar criteria in making this determination.
The 1998 Act eases several of these restrictions. It eliminates the “grossly erroneous ” standard; now, it is suffi-cient if the deduction is simply erroneous. This alleviates the need to prove that the deduction has no basis in law or in fact. The 1998 Act also eliminates the income thresh-olds.
The 1998 Act, in addition, adds several new relief pro-visions. It provides for partial relief where spouses are partially innocent. The 1998 Act states that, if the inno-cent spouse establishes that, in signing the return, he or she did not know, and had no reason to know, the extent the understatement, the spouse can be relieved of liability to the extent of the understatement of tax that he or she did not know of and had no reason to know of. It is not clear how this will be applied. The Conference Committee Report contains some language that suggest that it means only that relief can be provided on an item-by-item basis. In other words, a spouse may qualify as innocent with respect to one disallowed deduction that attributes to the understatement but not he innocent with respect to another such deduction. In such a case, the innocent spouse would be entitled to only partial relief.
The IRS is further authorized to provide equitable relief in cases where innocent spouse relief or separate return filing election (discussed below) is not available where the circumstances warrant such relief. The Conference Committee Report instructs the IRS to use this authority not only in understatement of tax cases but also in under payment of tax situations, i.e., where a spouse did not know and had no reason to know, that funds intended to be used to pay joint return taxes were instead taken by the other spouse and used by such other spouse for his or her personal benefit.
Separate Liability Election
The 1998 Act provides a new election that certain spouses may use to limit their liability for deficiencies related to a joint income tax return. In general, under this election, liability is limited to the amount of the deficiency arising from items that would have been allocable to the spouse had he or she filed a separate return in the first place. To qualify for this election, the spouse must meet one of the following conditions: the spouse is (1) no longer married to the spouse with whom be or she filed a joint return (this includes widows); (2) is legally separated from such spouse; or (3) has not lived in the same household with such spouse at any time during the preceding 12 months.
Under this election, a spouse will be liable only for that portion of a tax deficiency that is attributable to items allocable to that spouse (determined without regard to community property laws). Generally, wages will be allocated to the spouse who earned them and business income to the spouse who owns the business or investment that produced the income. Income from jointly owned businesses or investments will he allocated equally between the spouse unless there is clear and convincing evidence that supports a different allocation. Business deductions should be allo-cated to the owner of the business. Personal deductions should generally be allocated equally between the spouses unless evidence shows that a different allocation is appropriate. As an example, the committee report states that, where an asset contributed to a charity was the other spouse’s property and the deficiency is due to a valuation overstatement, equal division may not be appropriate.
Notwithstanding the proper allocation of income and deductions, the IRS is directed to prescribe regulations that will require that an item be allocated from one joint filer to the other to the extent the item created a tax benefit for the other. The electing spouse bears the burden of proof of establishing his or her portion of the tax deficiency and it will be critical to maintain proper records in order to do so.
A number of limitations apply to prevent abuse of this provision. First, if the IRS can demonstrate that. at the time of signing the joint return, the electing spouse had actual knowledge of any item giving rise to the deficiency, the electing spouse cannot elect out of joint and several liability for such item (unless the electing spouse can show that he or she signed the joint return under duress). The Senate and Conference Committee Reports state that actual knowledge must be established and cannot be inferred based on indications that the electing spouse had reason to know.
Second, an electing spouse’s liability is increased by the value disqualified assets. These are any assets transferred by the other joint filer to the electing joint filer for the principal purpose of avoiding tax. Any transfer between joint filers within one year preceding the date that the first notice of deficiency of tax is sent is presumed to have been for tax avoidance. This presumption can be rebutted. The presumption does not apply to transfers made pursuant to a decree of divorce or separate maintenance. Third, an election will be invalid if the IRS demonstrates that the taxpayers transferred assets between them-selves as part of a fraudulent scheme.
Time of Election for Innocent Spouse or Separate Return Relief Taxpayers who want to claim innocent spouse relief or elect separate return relief, or both, may do so up to two years after the date the IRS begins collection activities against such taxpayer. Such collection activities include the garnishment of wages or the issuance of a notice of levy. The issuance of a notice of deficiency and demand for payment addressed to both spouses will not trigger the two-year limitation period. (Under a transition rule, the two-year period will not expire until two years after the date of the first collection activity that occurs after July 22.)
There appears to he little advantage, and possible harm, to filing protective elections when it appears a marriage is heading toward divorce. A protective election could invite greater IRS scrutiny. Some commentators have suggested that the filing could trigger the two-year statute of limitations period. Since the IRS has three years from the date of filing a return to assess additional taxes (six years if more than 25 percent of gross income is omitted from the return), if the filing of a protective election does trigger the two-year period the two-year period could tick by before the IRS has even commenced an audit of the spouses’ joint return. In addition, the filing of a protective election may evidence actual knowledge on the part of the filing spouse that something is amiss in the return. This could later be used by the IRS to deny separate return re-lief on the basis of actual knowledge.
The only potential benefit for filing a protective election is to make sure that the spouse does not ignore the commencement of collection activities and let the two-year period lapse before taking action. However, it is usu-ally quite apparent when collection activities begin; in fact such actions are difficult to ignore. Even taxpayers who ignore IRS notices of tax due typically sit up and take no-tice when the word levy or lien is prominently featured in IRS correspondence. In addition the Conference Committee Report instructs the IRS to send separate notices to each spouse where feasible. For example where notifica-tions are being sent by registered mail, the Report states that “it is expected a separate notice will be sent by registered mail to each spouse. This will increase the likeli-hood that separated or divorced spouses will each receive such notice.” Taxpayers should also be careful to notify the IRS of address changes.
An electing spouse should consider both claiming innocent spouse and electing separate return relief. The scope of the two provisions and the conditions that must be met to obtain relief is different. For example, an innocent spouse must prove that he or she did not know of the erroneous items and had no reason to know. In the case a spouse electing separate return liability, the IRS must demonstrate that the taxpayer actually knew of the erroneous item in order to deny separate return relief. If a spouse has not maintained records and is not able to prove what his or her separate portion of the deficiency should be, the spouse may nevertheless be able to prove innocence. In fact, the lack of business records and access to business records may support a claim that the electing spouse was not involved in the business and innocent of any deficiencies related to such business.
Tax Court Review
If a joint filer is denied an election for either innocent spouse or separate return relief, the taxpayer may petition the U.S. Tax Court for review. A petition must be filed on the earlier of (1) 90 days following the date on which the IRS mails a determination that the taxpayer is not entitled to relief, or (2) six months after the election was filed.
The principles of res judica apply. A prior, final Tax Court decision is conclusive on all of the tax issues, in-cluding the question of whether one of the joint filers qualifies for innocent spouse or separate return relief if such spouse meaningfully participated in the prior Tax Court proceeding. If the spouse did not meaningfully participate in the prior Tax Court proceeding, an exception is provided and that spouse can petition the Tax Court on the sole question of whether he or she qualifies for innocent spouse or separate return relief.
If a U.S. district court or the Court of Claims acquires jurisdiction for a refund suit for the same tax years, the Tax Court cedes jurisdiction over innocent spouse or sepa-rate return relief to such courts.
Notices to Other Spouse of Proceedings
The other joint filer must be given notice of any admin-istrative or Tax Court proceeding in which a joint filer is claiming innocent spouse or separate return relief. The IRS and the Tax Court are instructed to establish rules to give the other joint filer adequate notice of the claim for relief and opportunity to participate in the proceeding.
Restrictions on Collection Activity
Once an election for innocent spouse or separate return relief is filed, the IRS cannot begin or proceed with a levy or collection action for an assessment to which the election relates until the 90-day period for petitioning the Tax Court expires or a Tax Court decision becomes final.
An exception is made for termination and jeopardy col-lection actions. which permits the IRS to circumvent normal procedures when it determines that the collection of tax will be jeopardized by delay and immediate assess-ment and collection is required to protect the fisc. (A jeopardy assessment relates to tax years for which a tax return is already due. A termination assessment relates to tax years for which a return is not yet due and serves to terminate the taxpayer’s year for the purpose of computing the amount of tax due.)
Explanation of Joint and Several Liability
Many married taxpayers do not understand the legal consequences of filing joint income tax returns and are surprised to find that they can be held liable for 100% of the taxes due. The l998 Act requites the IRS to clearly alert married taxpayers of their joint and several liabilities on all appropriate publications and instructions. The IRS is also required to notify taxpayers about their right to claim innocent spouse and elect separate return relief.
The 1998 Act revisions to the innocent spouse relief provision and its enactment of the new separate return election provision will significantly benefit taxpayers trapped in a tax nightmare of their ex-spouse’s making. The relief provided, however, is subject to numerous limitations and cannot be relied upon as an alternative to good up-front tax planning. Taxpayers who sign joint returns should beware of the potential liability they face and exercise considerable diligence to make sure the joint return accurately reflects both spouses’ income and deductions.
Marilyn Barrett practices law in Los Angeles.
She can be reached at (310) 788-0028