The innocent spouse rules are complicated. There are three possible alternatives that can result in innocent spouse relief.
The first alternative is Traditional Innocent Spouse Relief, in Section 6015(b), is 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.
The second alternative is Spousal Allocation, described in Section 6015(c). An electing spouse may allocate any tax deficiency in proportion to each spouse's contribution to the deficiency. The allocation is made without regard to community property laws.An 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. Additionally, 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 will not apply. This rule doesn't apply if the individual with actual knowledge establishes that he or she signed the return under duress.
The question arises of what actual knowledge the individual must have for this rule to not apply. If the spouse reviews the tax return, and sees that $25,000 was deducted for a contribution to the Society for the Preservation of Aardvarks, but doesn't have actual knowledge that the Society is not a valid 501(c)(3) organization does the election apply.
In Chesire v. Commissioner, 115 T.C. 183 at 195, the Court held that the knowledge required under section 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. The spouse is not, however, required to have actual knowledge that the income is subject to tax. For example, if the 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 then that will establish actual knowledge.
In King v. Commissioner, 116 T.C. 198 (2001), the Tax Court interpreted the actual knowledge requirement of section 6015(c)(3)(C) in the context of a case involving disallowed deductions. The Court went on to note that section 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. 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 join 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.
The liability of the spouse is increased by the value of any "disqualified asset" transferred to the innocent party, in Section 6015(c)(4)(A). A disqualified asset is any property or right to property transferred by the other spouse to the innocent party 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 rebuttable, under Section 6015(c)(4)(B)(ii)(II). Additionally, under section 6015(c), no refunds are allowed for innocent spouse relief granted.
The third alternative is Equitable Relief. This alternative authorizes the IRS to issue rules under which "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 [Section 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. Notice 2012-8 sets forth a proposed revenue procedure updating how the IRS will apply section 6015(f). The proposed revenue procedure generally makes it easier to obtain equitable innocent spouse treatment than under the previous IRS guidance i.e. Rev. Proc. 2003-61, 2003-2 C.B. 296. According to the Notice, until the revenue procedure is finalized, a taxpayer can elect to apply the requirements of the Notice, or Rev. Proc. 2003-61. Nevertheless the Tax Court has refused to apply the provisions the Notice until it is finalized. Hudgins v. Commissioner, T.C. Memo 2012-260.
Threshold Conditions for Equitable Relief
A requesting spouse must satisfy ALL of the following threshold conditions to be eligible to submit a request for equitable relief under section 6015(f). See Rev. Proc. 2003-61, 2003-2 C.B. 296 and Notice 2012-8.
1. The requesting spouse filed a joint return for the taxable year for which he or she seeks relief.
2. Relief is not available under section 6015(b) or (c).
3. Time for filing claim for relief:
a) If the requesting spouse is applying for relief from a liability that remains unpaid, the request for relief must be made before the expiration of the period of limitation on collection of the income tax liability, as provided in section 6502. Generally, that period expires 10 years after the assessment of tax, as written in Section 6502.
b) Claims for credit or refund of amounts paid must be made before the expiration of the period of limitation on credit or refund, as provided in section 6511. Generally, that period expires three years from the time the return was filed or two years from the time the tax was paid, whichever is later.
c) This is a significant change to the requirement in Revenue Procedure 2003-61, section 4.01(3) and Treas. Reg. ß 1.6015-5(b)(1) (TD 9003), that the requesting spouse's claim for equitable relief must be filed no later than two years after the date of the Service's first collection activity. See Notice 2011-70.
4. No assets were transferred between the spouses as part of a fraudulent scheme by the spouses.
5. The non-requesting spouse did not transfer disqualified assets to the requesting spouse. For this purpose, the term "disqualified asset" has the meaning given the term by section 6015(c)(4)(B). A disqualified asset is any property or right to property transferred by the other spouse to the innocent party 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 rebuttable. Section 6015(c)(4)(B)(ii)(II). This condition will not result in the requesting spouse being ineligible for relief if the non-requesting spouse abused the requesting spouse or maintained control over the household finances by restricting the requesting spouse's access to financial information, or the requesting spouse did not have actual knowledge that disqualified assets were transferred.
6. The requesting spouse did not knowingly participate in the filing of a fraudulent joint return.
7. The income tax liability from which the requesting spouse seeks relief is attributable (either in full or in part) to an item of the non-requesting spouse or an underpayment resulting from the non-requesting spouse's income, with the following exceptions:
(1) If an item is attributable or partially attributable to the requesting spouse solely due to the operation of community property law, then for purposes of the innocent spouse rules, that item (or portion thereof) will be considered to be attributable to the non-requesting spouse.
(2) Nominal ownership. If the item is titled in the name of the requesting spouse, the item is presumptively attributable to the requesting spouse. This presumption is rebuttable.
(3) Misappropriation of funds. If the requesting spouse did not know, and had no reason to know, that funds intended for the payment of tax were misappropriated by the non-requesting spouse for the non-requesting spouse's benefit, the Service will consider granting equitable relief although the underpayment may be attributable in part or in full to an item of the requesting spouse.
(4) Fraud committed by non-requesting spouse. The Service will consider granting relief notwithstanding that the item giving rise to the understatement or deficiency is attributable to the requesting spouse, if the requesting spouse establishes that the non-requesting spouse's fraud is the reason for the erroneous item.
Our next newsletter will cover Streamlined Determinations and other conditions required for Innocent Spouse Relief to be granted.
Find out more about Innocent Spouse Relief at the 2012 American Bar Association 29th Annual Institute on Criminal Tax Fraud and the 2nd National Institute on Tax Controversy. I will be discussing this topic as part of a panel. The conference will take place from December 6-7 at the Wynn Hotel in Las Vegas, NV.
Please register here if you are interested in attending.