The Innocent Spouse Defense
First published in the Los Angeles Lawyer
Lawyers in general-and tax, bankruptcy, and family lawyers, in particular-are often confronted with the problems of clients who have actual or prospective liabilities to the Internal Revenue Service. Sometimes these liabilities are caused by a former spouse who omitted income on a joint tax return or claimed an improper deduction.
A problem arises in this situation because individuals who sign joint tax returns are generally jointly and severally liable for any tax due.1 This liability extends not only to the tax due with the return, but to any additional amounts owed as a result of an IRS audit, including interest and penalties on deficiencies. Congress has provided, however, that if one spouse is "innocent," then he or she is not liable for these additional taxes,2 and the entire burden falls on the other, "non-innocent" spouse. Status as an innocent spouse can be obtained by convincing the IRS or the courts that:
1) A joint income tax return has been filed;
2) There is a "substantial understatement" of tax attributable to "grossly erroneous items" of one spouse;
3) In signing the return, the other spouse did not know, and had no reason to know, that there was a substantial understatement; and
4) Under the circumstances, it is inequitable to hold the other spouse liable for the tax deficiency.3
These conditions are conjunctive: failure to satisfy any one will bar the client from relief. 4 Determining whether the first requirement has been met is not difficult, since the IRS will not be asserting liability unless a joint return has been filed. Problems can arise, however, if no tax return was filed and the Service is alleging liability against the spouses separately for their share of the community property income. Since in this case there is no joint tax return, the first requirement of the innocent spouse rules cannot be established. Nevertheless, in appropriate cases, relief may be available under other provisions of the tax code.5
Determining whether the second requirement has been met requires an understanding of certain statutory definitions. "Grossly erroneous" items comprise two categories. One is any item of gross income attributable to the culpable spouse which is not reported on the tax return (omitted income).6 The other is any deduction, credit or claim of basis taken on the tax return by the culpable spouse if there was no basis in fact or law for the claim (erroneous deduction).7 Innocent spouse protection therefore does not apply to unpaid liabilities disclosed on the originally filed tax return. Community property laws are usually disregarded in determining whether an item of gross income is attributable to one spouse. However, when an item of gross income is derived from property, the legal definition of community property is used to determine to which spouse (or both spouses) the income is attributed.8 For example, capital gains on the sale of stock purchased with the husband's earnings during the course of the marriage would be considered community property and therefore one-half would be attributable to each spouse. Thus, each spouse could qualify for innocent spouse treatment with respect to the other half.9
An erroneous deduction has no basis in fact if it was never incurred.10 A deduction has no basis in law when the item is not deductible under well-settled principles of law, or where no substantial legal argument can be made to support its deductibility.11 A deduction which is frivolous, fraudulent, or phony, has no basis in fact or law.12 Merely because a deduction is disallowed for lack of substantiation does not establish that it had no basis in fact or law.13 Nor does a concession by the taxpayer that the deduction is improper prove that it was grossly erroneous.14 The Tax Court has interpreted the grossly-erroneous requirement very narrowly. In one case, the Tax Court held that where a taxpayer mischaracterized certain income as exempt in the mistaken belief that it was subject to the exclusion for foreign earned income, there was neither an omission from gross income nor an erroneous deduction, and therefore innocent spouse relief was unavailable.15
In another case, on his joint return, a taxpayer failed to properly classify his wife's income as self-employment income, and thus no self-employment tax was paid. Since the income was reported, but merely misclassified, the Tax Court held the tax was not attributable to an omission of income or an erroneous deduction or credit, and thus the taxpayer was not an innocent spouse.16
The grossly erroneous item must also cause a substantial understatement of tax.17 An understatement is substantial if it exceeds $500.18 If innocent spouse treatment is based upon an erroneous deduction, then the understatement of tax must also exceed a specified percentage of the innocent spouse's income.19 (This requirement need not be satisfied if innocent spouse treatment rests on an omission of gross income.20) The percentage depends upon the innocent spouse's adjusted gross income in the "pre-adjustment year,"21 which is the year immediately preceding the year in which the IRS mailed its notice of deficiency to the innocent spouse.22
If the innocent spouse has adjusted gross income of $20,000 or less in the pre-adjustment year, then innocent spouse treatment is not available unless the tax, interest and penalty from which the spouse is seeking to be relieved exceeds 10% of the adjusted gross income in that year.23 If the innocent spouse has adjusted gross income of more than $20,000 in the pre-adjustment year, that percentage increases to 25 percent of adjusted gross income.24 If the innocent spouse had remarried at the end of the pre-adjustment year, then, in computing the amount of adjusted gross income, the income of the new spouse is included, whether or not a joint tax return with the new spouse was filed.25
Deciding whether the third test (whether the spouse knows or has reason to know of the substantial understatement) has been met can be problematic. The standard is whether a reasonably prudent person in the taxpayer's position would be expected to know that the tax liabilities shown on the return were underreported or that further inquiry was warranted.26
Some courts have distinguished between cases involving omitted income and those involving erroneous deductions. If the culpable spouse has omitted income from the joint tax return, the putative innocent spouse must prove that he or she was not aware of the transactions leading to the understatement in order to show that there was "no reason to know that there was a substantial under-statement."27 Proving that the innocent spouse was not aware of the tax consequences of the transaction is insufficient.
In erroneous deduction cases, mere knowledge of the transaction, by itself, may not prevent relief. Some circuits, including the Ninth, have held that a spouse need only prove that he or she had no reason to know of the tax consequences of the transaction, and it is accordingly unnecessary to prove a lack of awareness of the circumstances that gave rise to the error.28 The Tax Court, however, has indicated that it will continue to follow the more restrictive knowledge-of-the-transaction standard, except in those circuits where it has been reversed.29 While the Tax Court is bound to follow Ninth Circuit precedent when ruling on cases within that circuit,30 it can hardly be expected to expand on that precedent.31 Taxpayers who can afford to pay the tax and litigate their case in a Ninth Circuit federal district court -- rather than in a tax court -- may be well advised to do so, since the district court could take a more expansive view of the Ninth Circuit's favor-able holdings.
Whatever the choice of venue, among the factors the court will consider in determining whether the alleged innocent spouse had "reason to know" are:
1) The spouse's level of education;
2) The spouse's involvement in the family business and financial affairs;
3) The presence of expenditures that appear lavish or unusual when compared to the family's past levels of income, standard of living, and spending patterns; and
4) The culpable spouse's evasiveness and deceit concerning the couple's finances.32
Even if a spouse is unaware of sufficient facts that would provide a reason to know of the understatement, he or she may know enough to have warranted further investigation. Thus, if the spouse knows sufficient facts such that a reasonably prudent taxpayer in that position would be led to question the legitimacy of the deduction, and this duty of inquiry is not satisfied, he or she may have constructive knowledge of the understatement imputed.33 In Price v. Commissioner,34 the size of the deduction (approximately 90 percent of the reported gross income), and its unusual nature (a Colombian gold mine) was sufficient to require the wife to make further inquiry into the bona fides of the deduction. However, once she asked her husband about the nature of the deduction, and he assured her that it had been reviewed by their accountant, she had satisfied her duty of inquiry.
A spouse's role as a homemaker or deference to the other spouse's judgment is not sufficient by itself to establish that he or she had no reason to know of the under-statements.35 On the other hand, evidence of an abusive relationship may establish that there was no duty of inquiry. In Kistner v. Commissioner,36 the wife enjoyed a lavish lifestyle even though the joint tax returns reflected significant net losses. The Tax Court held that these circumstances were sufficient to give the wife a duty to make further inquiry despite the facts that she did not have a high school diploma and was not involved in the family finances or family business. On appeal, the Eleventh Circuit reversed, citing her husband's history of physical abuse and his threats of violence if she questioned the tax returns.
Another element that tends to establish a putative innocent spouse's duty of inquiry are expenses, of which the spouse has knowledge, that exceed the reported income on the tax return.37 However, negative cash flow by itself does not necessarily imply that income has not been reported.38
Factors used to examine the final requirement for granting innocent spouse status -- that it would be inequitable to hold the spouse liable for the taxes in light of all the circum-stances -- include:
1) The probable future hardship that the spouse seeking relief would suffer if the relief were denied;39
2) Whether the alleged innocent spouse significantly benefited from the under-statement of tax;40 and
3) Whether the spouse seeking relief has been deserted.41
The most important of these factors is whether the taxpayer seeking relief significantly benefited from the under-statement of tax.42 Normal support, however, is not considered to be a significant benefit.43 In determining the existence of a significant benefit, the Tax Court compares the innocent spouse's standard of living in the year of the understatement with the standard of living in prior years.44
Normal support is measured in terms of the financial circumstances of the parties involved; it is not absolute.45 This rule sometimes leads to apparently anomalous results. In Kistner, the husband received, but did not report, constructive dividends from his corporation that were used to pay for various personal expenses. When asked to decide whether the wife had received a significant benefit from those dividends, the Tax Court examined the couple's lifestyle, noting that they lived on a ten-acre estate and owned an adjacent property that included a swimming pool, tennis court, clubhouse, and an airplane landing strip. They also maintained a separate home in Florida. The residences were kept up by two full-time employees, and the couple traveled to Europe and the Caribbean on a number of occasions, sometimes flying on one of the three private planes owned by the husband's corporation. In each of the years at issue, the wife received a new Mercedes automobile.
While the Tax Court acknowledged that the couple lived a "very affluent lifestyle," it pointed out that the lifestyle was not unusual in light of the husband's net worth of almost $9 million. Furthermore, their lifestyle did not improve in the years at issue. The court therefore concluded that the wife had not significantly benefited from the omitted income.
In contrast, in Kaye v. Commissioner,46 the taxpayers owned a home of unspecified value in Orange County. In addition, they purchased a condominium for $136,000 with a mortgage of $108,000. A man came once a week to clean their pool, and they employed intermittent domestic help. The wife testified that she lived "quite well" during the year at issue, and that she shopped in Beverly Hills. On this evidence, the court concluded that the parties lived a "luxurious lifestyle," and that it would not be inequitable to hold the wife liable for the tax deficiency. In another case,47 the Tax Court found that the alleged innocent spouse enjoyed a significant benefit from two one-week vacations abroad and the purchase of jewelry worth about $6,000.
While these results may at first seem disparate, a careful reading of the cases illustrates an important principle: the innocent spouse must establish a financial picture which demonstrates that the lifestyle enjoyed during the years at issue did not vary considerably from previous years, and therefore was not financed through the understatements on the tax returns.48
The inquiry on the existence of a significant benefit is not limited to those years in which the understatement occurred. Evidence of transfers of property to the putative innocent spouse in subsequent years through inheritance or life insurance proceeds trace-able to income omitted by the other spouse can constitute a significant benefit.49 How-ever, if the transfer of property amounts to reasonable support based upon the circumstances of the parties, it will not bar relief.50
A spouse who receives property in a marital settlement may be required to prove that the property received was not traceable to funds generated by the understatement.51 Thus, counsel should be prepared to prove that any property received by the putative innocent spouse is not traceable to omitted income, but rather to funds acquired before the understatement arose. One method of doing so is to show that income was diverted by the culpable spouse to such activities as gambling, extramarital affairs, or other illicit purposes.52 Such evidence may also invoke the sympathy of the IRS or the court.
It is true that several hurdles need to be cleared before an innocent spouse defense can be successful. Yet it remains a useful weapon in every lawyer's armory, especially when faced with an otherwise indefensible position taken on a joint tax return.Endnotes
1 Internal Revenue Code of 1986, as amended (hereinafter "I.R.C."), S6013(d)(3).
2 I.R.C. S6013(e).
4 Friedman v. Commissioner, 53 F.3d 523 (2nd Cir. 1995).
5 See, e.g., I.R.C. S66(c) providing for relief from liability for community income where a joint tax return has not been filed.
6 I.R.C. S6013(e)(2)(A).
7 I.R.C. S6013(e)(2)(B).
9 See Grubich v. Commissioner, T.C. Memo 1993-194.
10 Portillo v. Commissioner, T.C. Memo 1990-68, rev'd on other grounds, 932 F.2d 1128 (5th Cir. 1991).
11 Flynn v. Commissioner, 93 T.C. 355, 364 (1989).
12 Douglas v. Commissioner, 86 T.C. 758 (1986).
13 Id. at 762.
14 Purcell v. Commissioner, 86 T.C. 228 (1986), aff'd., 826 F.2d 470 (6th Cir. 1987).
15 Winnett v. Commissioner, 96 T.C. 802 (1991).
16 Wolski v. Commissioner, T.C. Memo 1994-296.
17 I.R.C. S6013(e)(1)(B).
18 I.R.C. S6013(e)(3).
19 I.R.C. S6013(e)(4).
20 I.R.C. S6013(e)(4)(E).
21 I.R.C. S6013(e)(4).
22 I.R.C. S6013(e)(4)(C). With certain limited exceptions, if the Internal Revenue Service intends to collect additional tax not shown on a taxpayer's income tax return, and the taxpayer does not agree to the assessment of additional tax, the Service must send the tax-payer a notice of deficiency by certified mail. I.R.C. S6211 et. seq.
23 I.R.C. S6013(e)(4)(A).
24 I.R.C. S6013(e)(4)(B). In calculating the amount of tax, interest and penalty from which the spouse would be relieved, accrued interest and penalties through the date of the issuance of the notice of deficiency are taken into account. However, any additional interest or penalty accrued after that date are not considered. Farmer v. United States, 794 F.2d 1163 (6th Cir. 1986).
25 I.R.C. S6013(e)(4)(D).
26 Stevens v. Commissioner, 872 F.2d 1499, 1504 (11th Cir. 1989).
27 See Guth v. Commissioner, 897 F.2d 441 (9th Cir. 1990).
28 Hayman v. Commissioner, 992 F.2d 1256 (2nd Cir. 1993); Erdahl v. Commissioner, 930 F.2d 585 (8th Cir. 1991); Price v. Commissioner, 887 F.2d 959 (9th Cir. 1989).
29 Bokum v. Commissioner, 94 T.C. 126, 151 (1990), aff'd., 992 F.2d 1132 (11th Cir. 1993).
30 Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff'd., 445 F.2d 985 (10th Cir. 1971).
31 See Lardas v. Commissioner, 99 T.C. 490, 498 (1992).
32 Price v. Commissioner, 887 F.2d at 965.
33 Price v. Commissioner, 887 F.2d at 965, 966.
35 Stevens v. Commissioner, 872 F.2d at 1505, 1506.
36 T.C. Memo 1991-463, rev'd., 18 F.3d 1521 (11th Cir. 1994).
37 Estate of Jackson v. Com-missioner, 72 T.C. 356 (1979).
38 Pietromonaco v. Commissioner, 3 F.3d 1342, 1347 (9th Cir. 1993) (In a society that relies heavily on credit, it is not unusual for expenditures to exceed income.).
39 Sanders v. United States, 509 F.2d 162, 171 (5th Cir. 1975); Streit v. Commissioner, T.C. Memo 1989-265.
40 Purificato v. Commissioner, 9 F.3d 290, 293 (3rd Cir. 1993).
41 Treas. Reg. S1.6013-5(b).
42 Buchine v. Commissioner, 20 F.3d 173, 181 (5th Cir. 1994).
43 Treas. Reg. S1.6013-5(b).
44 Kistner v. Commissioner, T.C. Memo 1995-66, citing Sanders v. United States, 509 F.2d 162, 168 (5th Cir. 1975).
45 Bell v. Commissioner, T.C. Memo 1989-107.
46 T.C. Memo 1995-345.
47 Michaels v. Commissioner, T.C. Memo 1995-294.
48 See, e.g., Estate of Krock v. Commissioner, 93 T.C. 672 (1989); Hill v. Commissioner. T.C. Memo 1990-367.
49 Treas. Reg. S1.6013-5(b).
50 Padgett v. Commissioner, T.C. Memo 1987-130.
51 Teplitz v. Commissioner, T.C. Memo 1978-45. However, in Padgett, Id., the Tax Court ruled that a person claiming the benefit of innocent spouse treatment is not required to explain the source of every payment received in a divorce proceeding in a subsequent year.
52 I.R.M. 45(11)(20)(July 12, 1989).
* 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 problems with the IRS and State taxing agencies. His practice focuses on the litigation of tax controversies in all Federal Courts, including the U.S. Bankruptcy Court. He also represents clients in audits, appeals and tax collection matters.