Innocent Spouse: Urban Legend or Viable Option
First presented to the:
Annual Meeting of the State Bar of California
- Three different possible Alternatives any one of which can result in innocent spouse treatment.
- A timely election in the form prescribed the IRS is necessary to obtain the benefits. The election must be made within two years of the date the IRS has begun collection action with respect to the innocent spouse.
- Election is made on Form 8857.
- When does collection action begin?
- Collection activity means a CDP levy notice; an offset of an overpayment of the requesting spouse against a liability under I.R.C. § 6402; the filing of a suit by the United States against the requesting spouse for the collection of the joint tax liability; or the filing of a claim by the United States in a court proceeding in which the requesting spouse is a party or which involves property of the requesting spouse. Collection activity does not include a notice of deficiency; the filing of a Notice of Federal Tax Lien; or a demand for payment of tax. The term "property of the requesting spouse," means property in which the requesting spouse has an ownership interest (other than solely through the operation of community property laws), including property owned jointly with the non-requesting spouse. Treas. Reg. Section 1.6015-5(b)(2)
- Even if the IRS began collection activity, if it failed to notify the requesting spouse of her rights under § 6015 then the two year period will not start to run. McGee v. Commissioner, 123 T.C. 314 (2004); Chief Counsel Notice 2005-010, 2005 CCN LEXIS 8 (2005)
- Traditional Innocent Spouse Relief - § 6015(b).
- Available to all joint filers regardless of current marital status. [Due to the impact of Community Property laws this is generally a non-starter in California].
- If there is an understatement of tax attributable to erroneous items of one spouse, and the other spouse establishes that he or she did not know and had no reason to know of the understatement, and it would be inequitable to hold that person liable, and the innocent spouse makes a timely election the individual will be relieved of liability for tax, interest, and penalties to the extent it is attributable to the understatement.
- Spousal Allocation. Section 6015(c). An Electing Spouse May Allocate A Tax Deficiency in Proportion to Each Spouse's Contribution to the Deficiency.
- The allocation is made without regard to community property laws.
- Election may be made only by an individual who at the time of the election is no longer married, or is legally separated from the other spouse, or who is not a member of the same household during the 12 month period ending on the date the election is filed.
- If the IRS proves that assets were transferred between individuals as part of a fraudulent scheme the election is invalid.
- If the IRS demonstrates that the individual making the election had actual knowledge at the time the return was signed of any item giving rise to a deficiency then the election is invalid. This rule doesn't apply if the individual with actual knowledge establishes that he or she signed the return under duress.
- Cheshire v. Commissioner,115 T.C. 183, 195 (2000), the Court held that the knowledge required under § 6015(c)(3)(C) "is an actual and clear awareness (as opposed to reason to know) of the existence of an item which gives rise to the deficiency." It went on to hold that in omitted income cases the requesting spouse must have an actual and clear awareness of the omitted income. Id. The spouse is not however, required to have actual knowledge that the income is subject to tax.
- e.g. Spouse receives a distribution from a pension plan, and honestly believes it was non-taxable. As long as she knew that there was a distribution from a pension plan then that will establish actual knowledge.
- In King v. Commissioner, 116 T.C. 198 (2001), the Tax Court interpreted the actual knowledge requirement of § 6015(c)(3)(C) in the context of a case involving disallowed deductions. The Court notes that § 6015(c) requires the IRS prove that the requesting spouse had actual knowledge of the factual circumstances which made the item unallowable as a deduction. King at 204. In King the deficiency arose because the husband couldn't establish his cattle-raising activity was entered into for profit. Petitioner made sure that all the records were kept together and submitted to their tax return preparer each year for inclusion in the joint income tax returns that she and intervenor filed. The court was satisfied that petitioner's knowledge of the cattle-raising activity was that it was an activity that she knew was not profitable but that she had expected would become profitable at some point. Respondent presented insufficient evidence to show that petitioner knew that her former spouse did not have a primary objective of making a profit with his cattle-raising activity.
- In Mora v. Commissioner, 117 T.C. 279, 292 (2001), the Tax Court applied the same test to a tax shelter loss. Mora involved a Hoyt cattle shelter partnership. The factual basis for the disallowed deduction in the Hoyt tax shelter cases generally centers on the lack of animals to sustain the deductions taken and an overvaluation of the animals that were available. The IRS could not prove that the wife had actual knowledge of these factual circumstances; however, the husband also didn't have actual knowledge of these facts. Nonetheless the wife was entitled to relief from liability with respect to the transaction.
- Liability is increased by the value of any "disqualified asset" transferred to the requesting spouse. § 6015(c)(4)(A).
- Disqualified asset is any property or right to property transferred by the non-requesting spouse to the requesting spouse if the principal purpose of the transfer is the avoidance of tax or the payment of tax.
- Any transfer made within one year prior to the issuance of the 30 day letter shall be presumed to have as its principal purpose the avoidance of tax, unless the assets were transferred pursuant a divorce decree or decree of separate maintenance or a written instrument incident to the decree. The presumption is rebutable. § 6015(c)(4)(B)(ii)(II).
- No refunds are allowed for innocent spouse relief granted under the allocation rules of § 6015(c).
- Alternative III. Equitable Relief. Section 6015(f). The third alternative authorizes the IRS to issue rules under which it "may" relieve a spouse of liability if relief is not available under the first two alternatives, and taking into account all the facts and circumstances it would be inequitable to hold the individual liable. I.R.C. § 6015(f). A fundamental distinction of this provision is that, unlike the first two it permits relief for tax amounts shown on the return, but not paid, rather than just audit amounts determined by the IRS.
- Revenue Procedure 2003-61 provides that in order to obtain equitable relief the taxpayer must meet all of the following threshold requirements:
- The requesting spouse filed a joint return for the taxable year for which he or she seeks relief.
- Relief is not available to the requesting spouse under § 6015(b) or (c).
- The requesting spouse applies for relief no later than two years after the date of the Service's first collection activity after July 22, 1998, with respect to the requesting spouse.
- No assets were transferred between the spouses as part of a fraudulent scheme by the spouses.
- The non-requesting spouse did not transfer disqualified assets to the requesting spouse. If the non requesting spouse transferred disqualified assets to the requesting spouse, relief will be available only to the extent that the income tax liability exceeds the value of the disqualified assets. For this purpose, the term "disqualified asset" has the meaning given the term by §6015(c)(4)(B).
- The requesting spouse did not file or fail to file the return with fraudulent intent.
- The income tax liability from which the requesting spouse seeks relief is attributable to an item of the individual with whom the requesting spouse filed the joint return (the "non requesting spouse").
- If the requesting spouse meets all of the above requirements then relief will generally be granted by the IRS if the following conditions are met:
- On the date of the request for relief, the requesting spouse is no longer married to, or is legally separated from, the non-requesting spouse, or has not been a member of the same household as the non requesting spouse at any time during the 12-month period ending on the date of the request for relief.
- On the date the requesting spouse signed the joint return, the requesting spouse had no knowledge or reason to know that the non requesting spouse would not pay the income tax liability. The requesting spouse must establish that it was reasonable for the requesting spouse to believe that the non requesting spouse would pay the reported income tax liability. If a requesting spouse would otherwise qualify for relief under this section, except for the fact that the requesting spouse's lack of knowledge or reason to know relates only to a portion of the unpaid income tax liability, then the requesting spouse may receive relief to the extent that the income tax liability is attributable to that portion.
- The requesting spouse will suffer economic hardship if the Service does not grant relief. For purposes of this revenue procedure, the Service will base its determination of whether the requesting spouse will suffer economic hardship on rules similar to those provided in Treas. Reg. §301.6343-1(b)(4).
- Even if these conditions are not met the IRS may grant equitable relief. Rev. Proc. 2003-61. § 4.03. The IRS will review the all of the facts and circumstances in making a determination whether it would be inequitable to hold the requesting souse liable. Rev. Proc. 2003-61, § 4.03(2) sets forth the following list of applicable factors that are used in making the determination.
- Marital status. Whether the requesting spouse is separated (whether legally separated or living apart) or divorced from the non requesting spouse.
- Economic hardship. Whether the requesting spouse would suffer economic hardship (within the meaning of § 4.02(1)(c) of this revenue procedure) if the Service does not grant relief from the income tax liability.
- Knowledge or reason to know. In the case of an income tax liability that was properly reported but not paid, whether the requesting spouse did not know and had no reason to know that the non requesting spouse would not pay the income tax liability.
- Non-requesting spouse's legal obligation. Whether the non-requesting spouse has a legal obligation to pay the outstanding income tax liability pursuant to a divorce decree or agreement. This factor will not weigh in favor of relief if the requesting spouse knew or had reason to know, when entering into the divorce decree or agreement, that the non requesting spouse would not pay the income tax liability.
- Significant benefit. Whether the requesting spouse received significant benefit (beyond normal support) from the unpaid income tax liability or item giving rise to the deficiency.
- Compliance with income tax laws. Whether the requesting spouse has made a good faith effort to comply with income tax laws in the taxable years following the taxable year or years to which the request for relief relates.
- Tax Court Review. Section 6015(e).
- An individual may petition the Tax Court for innocent spouse relief within 90 days of the issuance by certified or registered mail by the IRS of a notice of determination with regard to the relief available. This is usually referred to as a "stand alone" case.
- Trap for Unwary Bankruptcy Lawyers. Taxpayers cannot file a petition with the Tax Court during the pendency of a bankruptcy case, as it violates the automatic stay provisions in Bankruptcy Code § 362(a)(8) (barring any action against or concerning a debtor or the debtor's property). However the 90 day period for filing a Petition with the Tax Court does not toll during bankruptcy. Therefore a taxpayer who receives a Notice of Determination that she is not an innocent spouse during the pendency of a bankruptcy can permanently lose her right to Tax Court review. Drake v. Comm'r, 123 T.C. 320 (T.C. 2004). A bankruptcy lawyer faced with this problem should consider requesting relief from the bankruptcy stay in order to permit the filing of a Tax Court petition. It might also be possible to litigate the innocent spouse claim in bankruptcy court. See In re Hinckley, 256 Bankr. 814 (Bankr. M.D. Fla. 2000) (debtor permitted to raise § 6015 claim in objection to the Commissioner's proof of claim); French v. United States, 242 Bankr. 369 (Bankr. N.D. Ohio 1999) (debtor permitted to raise § 6015 claim in adversary proceeding brought pursuant to 11 U.S.C. § 505(a)).
- Even if no determination letter is issued by the IRS, a taxpayer may file a petition with the Tax Court at any time after six months from the filing of the election has expired, but not after 90 days after the determination letter has been issued. Friday v. Commissioner, 124 T.C. (No. 13) (2005). Alternatively innocent spouse relief may be raised as an affirmative defense in a Tax Court Petition filed in response to an IRS deficiency determination, or in a petition filed in response to a Notice of Final Determination following a collection due process hearing pursuant to §§ 6330 or 6320. Billings v. Commissioner, 127 T.C. No. 2 (2006).
- In a petition filed with the Tax Court, the requesting spouse must establish that denial of relief was an abuse of discretion. This means that the petitioner must show that the IRS acted arbitrarily, capriciously, or without a sound basis in fact. Jonson v. Comm'r., 118 T.C. 106 (2002), aff'd, 353 F.3d 1181 (10 Cir. 2003). Nevertheless, the determination is made de novo by the Tax Court. Ewing v. Comm'r, 122 T.C. 32, 42 (2004), reversed on other issues, 439 F.3d 1009 (9 Cir. 2006).
- Generally the IRS may not collect any tax to which the election under § 6015(b) or (c) relates until the 90 day period expires, or the Tax Court decision becomes final. § 6015(e)(1)(B).
- The collection statute is suspended during the period the IRS is prohibited from levying plus 60 days thereafter. The statute of limitations suspension only applies to elections under IRC §§ 6015(b) and (c) but not (f).
- Tax Court review may not be available to individuals seeking equitable relief pursuant to § 6015(f).
- In a series of cases each involving slightly different procedural circumstances the Tax Court held that it had jurisdiction to review the IRS' determination that a taxpayer was not entitled to equitable relief. Fernandez v. Commissioner, 114 T.C. 324 (2000), nonacq. AOD 2004-05 reversing AOD 2000-06. (Tax Court has jurisdiction under § 6015(e) in a "stand-alone" proceeding to review a denial of equitable relief, if an election was also made under § 6015(b) or (c)); Ewing v. Commissioner, 118 T.C. 494 (2002) rev'd. 439 F.3rd 1009 (9 Cir. 2006). Tax Court has jurisdiction in a § 6015(e) stand-alone case to review a denial of relief where only equitable relief was elected.) Indeed in Chief Counsel Notice N(35)000-338, the IRS had taken the position that not only the Tax Court, but the District Courts and the Court of Federal Claims have jurisdiction to hear stand-alone claims for relief under § 6015(f). Recently, however, the IRS has reversed its position, and after two reversals in the Appellate Courts, the Tax Court has reversed itself, and will no longer hear §6015(f) cases where there has been no deficiency asserted. Billings v. Commissioner. 127 TC No. 2 (2006). It will however, hear requests for equitable relief if a deficiency was asserted. It can also hear requests for equitable relief if it is raised as an issue in a collection due process hearing subject to §§ 6330 and/or 6320. Id.
- As of this writing there is Legislation pending which would remedy this problem. Senate Bill 1321
- The non-filing party is to be given adequate notice, and an opportunity to intervene in the proceeding for spousal relief under §§ 6015(b)and (c). §6015(e)(4). Corson v. Commissioner, 114 T.C. 354 (2000), as well as under § 6015(f). Van Arsdalen v. Commissioner, 123 T.C. 135 (2004). The intervener may either dispute or support the requesting spouse's claim for relief. id. See, Tax Court Rule 325.
- However in standalone cases the non-requesting spouse does not have right to request Tax Court review of the IRS' administrative determination to grant innocent spouse status to the requesting spouse. Maier v. Commissioner, 119 T.C. 267 (2002), affd 360 F.3d 361 (2nd Cir. 2004).
- Practice Tip. Consider requesting innocent spouse status for the "non-requesting" spouse.
- VII. Relief from joint tax liability does not preclude liens on community property. U.S. v. Stolle, 2000-1 U.S. Dist. LEXIS 5454 (C.D. C.A., 2000); Ordlock v. Commissioner, 126 T.C. No. 4 (2006).
- Practice Tip. In divorce situations any property should be transferred quickly to the non-liable spouse before the IRS files its notice of federal tax lien.
*Dennis Brager, Esq.
, is a State Bar Certified Tax Specialist in Los Angeles. A former IRS senior trial attorney, Mr. Brager now devotes his efforts exclusively to helping clients resolve their tax problems with the IRS and California State tax agencies. Services include negotiating Tax Debts, Tax Fraud Representation, Tax Litigation, Tax Audit and Appeals Representation, Tax Preparer Penalty Mitigation, Payroll Tax Audits, and California Sales Tax Problems. He may be reached at 800.380.TAX LITIGATOR.
 All section references are to the Internal Revenue Code of 1986, as amended.
Thank you for your good work in resolving my innocent spouse case. I will be forever grateful!
It is a pleasure to send you this check...knowing I have friends like you who are there to help!
Words can not express my appreciation. YOU DID IT!!!! I have dealt with and paid multiple people to resolve my tax problems, however you were the only one who was successful...
I would like to thank you from the bottom of my heart for your help and insight. Thanks to you my kids and I might have some financial future and even a Christmas without fear.
Thank you for the FBAR reminder. I won't forget! -- How can I forget? ...! I also thank you for guiding me [in] making the right decision and putting the horrible time all behind!!!!