Innocent Spouse Relief

I.R.C. 6015

The United States Tax Court in Jane M. Lassek, Petitioner, and Michael E. Smith, Intervenor v. Comm’r, Docket No. 25395-16, Filed October 28, 2019 provided the Petitioner (wife) with partial innocent spouse relief for one year and denied relief for another.  The liabilities at issue begin with the 2011 year in which Intervenor (husband) prepared a return and improperly characterized his 401(k) distribution in the amount of $46,477 as nontaxable.  The Service determined a deficiency of $14,996 and penalties of $3,026.  The petitioner never reviewed the return as it was electronically filed by the Intervenor. In 2012, both took distributions from their retirement and both signed the return.  They had no plan for how they intended to pay the balance.  The parties ultimately divorced and their divorce decree was silent in regards to the tax liabilities. In reviewing the years at issue, the Court ruled that the Petitioner should be granted relief for the 2011 year under I.R.C. 6015 (c) – a section that limits a spouse’s liability to the portion of the deficiency properly allocable to that spouse under 6015(d).  This is available because the tax due did not appear on the face of the return. The Court granted relief because it did not believe that the Petitioner had actual knowledge of Intervenor’s 2011 401(k) distribution.  As for tax year 2012, the Petitioner failed to qualify for relief. She admitted at trial that she would not suffer economic harm if relief was not granted.  Further, Petitioner failed because she could not reasonably believe that Intervenor would or could pay the tax liability.  This case is a good review of the multi-level and multi-factor analysis of equitable relief under 6015(f).

Updated Guidance from the IRS on Innocent Spouse Relief

When married taxpayers file a return, they may elect to file that return jointly with their spouse.  Sometimes that is a mistake – a big one!  When filing a joint return, the Internal Revenue Code provides that both spouses will be jointly and severally liable for the tax, penalties and interest.  This blog has reviewed the various options available to spouses requesting that they be relieved from liability on the return. Just click on “Innocent Spouse Relief” under “Posts by Category” for a general  review.  Lately, we are seeing the IRS take action to update their analysis of Innocent Spouse Applications.

General guidelines provide that understatements of tax may qualify for relief under so-called “innocent spouse” or “separation of liability” provisions, while underpayments may only qualify under “equitable relief” provisions.  All three of these are under the umbrella of “innocent spouse relief” provided by the Internal Revenue Code.

Of note, earlier this year, the IRS updated internal guidance. One change made to internal guidelines earlier this year was to clarify provisions relating to actual or constructive knowledge of the understatement of tax.  Basically, in order to qualify under this particular type of Innocent Spouse relief, it is necessary to show that the requesting taxpayer did not know about the understatement and had no reason to know of the understatement.  If this requirement isn’t met, then the requesting spouse doesn’t qualify.  However, if the requesting spouse can establish that he or she was the victim of domestic abuse prior to the time that the return was signed, but did not sign the return under duress, and as a result of the prior abuse, did not challenge any of the items on the return for fear of retaliation, then the IRS will not review the requirement of showing that the requesting spouse did not know or did not have reason to know of the understatement.

Normally, the IRS will review the following factors to determine if the requesting spouse knew or had reason to know of the understatement, absent a showing of abuse: 1) the nature of the erroneous item and the amount of the erroneous item relative to the other items, 2) the couple’s financial situation, 3) the requesting spouse’s educational background and business experience, 4) the extent of the requesting spouse’s participation in the activity that resulted in the erroneous item, 5) whether the requesting spouse failed to inquire, at or before the time the return was filed, about items on the return or omitted from the return that a reasonable person would questions, and 6) whether the erroneous item represented a departure from a recurring pattern reflected in prior year’s returns.

The IRS has pending the finalization of procedures that weigh abuse in a spousal relationship more heavily in the analysis of relief under Innocent Spouse provisions.  Some of the changes mentioned here are based in internal guidelines associated with working applications for relief and acknowledge the proposed official guidance.  Should you have questions about Innocent Spouse relief, don’t hesitate to contact our office.

Innocent Spouse Relief: Income attribution

Income attribution rule addressed by Tax Court

In Connie L. Minton a.k.a. Connie L. Keeney v. Comm’r, T.C. Memo 2018-15, filed February 5, 2018, the Tax Court was asked to review an IRS Appeals’ decision denying innocent spouse relief based on equitable relief. In this case, taxpayer made application for relief after divorce. The return in question reflected income from a 401(k) withdrawal taxpayer instituted at the request of her former spouse – for the purpose of investing in a business venture that failed. Additionally, the spouse’s income from his business, along with a small amount of interest income was reported on the return. The Appeals officer indicated that the taxpayer’s request for relief failed because the tax was attributed to her income. Thus, it did not meet the threshold condition for relief. The Tax Court reviewed this decision and discussed the exceptions to the attribution rule. Those exceptions include: a) attribution due solely to the operation of community property law, b) nominal ownership, c) misappropriation of funds, d) abuse before the return was filed that affects the requesting spouse’s ability to challenge the treatment of items on the return or question payment of any balance due, and e) fraud committed by the nonrequesting spouse that is the reason for the erroneous item. Ultimately, the Court indicated that the taxpayer did not meet any of the exceptions and failed the threshold conditions as to her 401(k) withdrawal. The Tax Court, however, disagreed with Appeals in that they concluded the liability attributed to the nonrequesting spouse’s business income should not be attributed to the taxpayer because her involvement in the business was nominal only. This is a good discussion of some exceptions to the income attribution rule, not regularly reviewed by the Court.

Innocent Spouse Relief: Relief while married

Taxpayer obtains relief while still married

In Hudson v. Comm’r T.C. Summary Opinion 2017-7, filed February 8, 2017, the Tax Court granted equitable relief from joint and several liability under section 6015(f).  It is a rare case that the IRS grants relief to a taxpayer that requests innocent spouse relief, unless that individual is legally separated or divorced from the jointly liable taxpayer. The taxpayer and her husband remained legally married, but were essentially estranged.  Petitioner remained in the marriage because she “regards the vow of marriage as sacrosanct and does not believe in divorce.” The liability reported on the face of the return was largely from the early withdrawal penalty associated with Petitioner’s husband taking a distribution from his retirement account to finance the purchase of a piece of residential real estate – in his name alone. Though petitioner resided at this residence, the Tax Court did not believe she enjoyed a lavish lifestyle.  Petitioner held a bachelors degree and, while she was out of the workplace caring for their children during the year at issue, she later became employed in her field. At the time of filing the Petition in the Tax Court, she was unemployed and struggled with reasonable living expenses. The Court could not provide “streamlined” relief because the Petitioner remained married.  That triggered a facts and circumstances analysis where economic hardship and lack of significant benefit factored heavily into the Court’s grant of liability relief. 

Why do I have to owe over $10,000 to get help with my IRS tax debt?

Everyone has seen on television, or heard on the radio, advertisments for assistance with owing the IRS back taxes.  Turn on the TV late at night to watch reruns of your favorite show and you’re bound to see at least one. But they all have that caveat, saying that you must owe the IRS over $10,000 for them to help you, but why?

The fact of the matter is that you don’t need to owe a certain amount to have representation to assist with your tax debt – at least not from our firm.  If you listen to the television or radio you would think that there is no way to help someone who owes less than this amount.  Most of the businesses that advertise in this way are looking to submit a settlement proposal, known as an Offer in Compromise, to the IRS on your behalf.  This may or may not be possible, but generally that is the only service these businesses provide.  What they know is that due to the manner in which the IRS settles debt, it is nearly impossible to settle a small tax debt.  However, here are several situations that our office sees frequently where taxpayers have a small tax debt, but still need help sorting through their options to come into compliance:

  • Sometimes a client may owe the government a small amount, but has unfiled returns and is preparing to file bankruptcy to discharge health care debt or other obligations.  The bankruptcy code requires the taxpayer to file their last three returns in order to qualify for the bankruptcy.  After filing, the client anticipates owing more.  Perhaps that is a small amount or a large amount.  Regardless, this client needs help with those taxes because they will not be discharged in the bankruptcy.
  • A client may owe a small amount based on a return filed by the government – known as a Substitute for Return (SFR).  However, the client will owe much more later when a proper return is filed.  This can happen when a client is self-employed and receives a few 1099’s that comprise a small amount of the taxpayer’s overall revenue.  Once the return is properly completed, there may be a different picture.
  • Sometimes a client owes tax debt that their spouse created and it is simply unfair for them to be held responsible for the debt.  That client may want to be relieved from the obligation – no matter how small – through the Innocent Spouse Relief process.  Alternatively, a spouse may be harmed because his or her refund was offset to their spouses tax debt.  In this instance, this client may need assistance filing an Injured Spouse claim.
  • A client may have a few thousand dollar tax debt created by automated Exam at the IRS, but if the client merely pays it or sets up a payment agreement to resolve the balance, the taxpayer may be setting himself or herself up for problems with future tax return positions.  If your expense or other deduction is valid and the IRS disallowed it, it may be worth fighting to substantiate it so you do not create a record showing you agreed with the claim or deduction being disallowed.  Therefore, your representative could make arguments to assist in your exam and protect your position for later.
  • Some clients owe less than $10,000 and are interested in relieving themselves from the burdens of a tax lien.  It is now possible to establish a Direct Debit Installment Agreement and apply for a withdrawal of the tax lien.  There are specific procedures for this doing this must be met to qualify, but it is possible.  As a matter of fact, it is now possible to accomplish this if you owe up to $25,000.
  • A client may owe a small tax debt which was originally much larger and triggered the filing of a tax lien.  Though the debt is paid down, it is preventing the sale of a piece of real estate because there is not enough equity to retire the tax debt at closing.  These clients need assistance with a request to Discharge Property from Federal Tax Lien.  This will clear title to the property and allow for the closing, even though the entire tax debt is not being paid off in full.
  • Some of our clients only owe a couple of thousand dollars, but have many years of unfiled tax returns and anticipate owing much more.  A settlement proposal, Offer in Compromise, may be appropriate.  However, it is impossible to know if that is the case until the taxpayer knows the total owed and a financial analysis is performed which includes a review of income, expenses and equity in assets.
  • A client may need assistance when a wage levy is in place, but the balance on their total tax debt is not larger than $10,000.   In those instance, it is very likely that the taxpayer can be moved to a voluntary payment agreement if all returns are filed.  Even if all returns are not filed, substantiation to the IRS of income and expenses could likely result in a partial levy release to relieve the client of some, or all of the wage levy.
  • If any of the above is similar to your situation, or you have some other tax problem, we will be happy to help you, regardless of the size of your debt.  Just give us a call.

Innocent Spouse Relief

When spouses file a tax return together, they are held jointly and severally liable for the tax debt. Each spouse is legally responsible for paying the entire liability, including tax, additions to tax, penalties, and interest. Realizing that this may not be appropriate in all cases, the Internal Revenue Service offers “innocent spouse relief” to help spouses in a variety of situations. There are three different types of relief that fall under the umbrella of “innocent spouse relief”:

  1. Innocent Spouse Relief – you may obtain this type of relief if you filed a joint tax return and the return understated tax that is attributable solely to your spouse’s erroneous item. These items could be income received by your spouse, but not reported on the return or, the items could be incorrectly reported deductions, credits, or property bases attributed to your spouse. The effect of these items, the understatement of tax, would not appear on the return when you signed it. In other words, there was no tax due, or if there was tax due, the item left out and its effect was not shown on the face of the return. You must prove that at the time you signed the return, you did not know, and had no reason to know, that the tax was understated. Finally, when looking at the situation, you must prove it would be unfair to hold you liable for the understatement of tax.
  2. The next type of relief is known as “separation of liability” relief. Under this type, the understatement of tax, interest, and penalties is allocated between you and your spouse. In order to qualify for this type of relief you must no longer be married to, or are legally separated from, the spouse with whom you filed a joint return. You qualify under this provision if you are widowed. You must additionally not be a member of the same household as the spouse with whom you filed the joint return during the twelve (12) month period prior to filing your application for relief under this provision.
  3. It is very common for one spouse to seek relief from liability from a tax obligation clearly stated on the face of the return at the time of filing. If the liability is reflected on the face of the return, and not an understatement, then the only way to qualify for relief is through the third type of relief – “Equitable Relief.” In order to qualify for this type of relief, you must establish that taking into account all facts and circumstances, it would be unfair to hold you liable.

There are many factors relevant to relief under this provision. The IRS will consider if you would suffer economic hardship if relief is not granted. The IRS does factor in who is held liable for the taxes under a divorce decree or other agreement to pay the tax – even though the IRS is not bound by these agreements. The IRS will also look at whether or not you received significant benefit from the underpaid or understated tax and whether you knew or had reason to know about the item causing the understated tax or that the tax due would not be paid.

The IRS explicitly takes domestic violence and abuse into account when evaluating claims for innocent spouse relief, especially under the equitable relief provisions. In her most recent report to Congress, the National Taxpayer Advocate explained that “domestic violence and abuse, including economic abuse, have real consequences for tax administration.” See Annual Report to Congress by National Taxpayer Advocate, Most Serious Problems for more details about this issue. The Taxpayer Advocate indicates that about 16% of applicants for innocent spouse relief report that they are victims of domestic violence and abuse. To its credit, the IRS has revised all of its rules regarding review of innocent spouse applications and has expanded the effect abuse will have in determining if relief will be granted to the requesting spouse. The important fact is that domestic violence and abuse is a factor that is being reviewed in more detail than ever by the IRS in the analysis of a request for innocent spouse relief.

By regulation, the Department of Treasury and the IRS established a two year deadline to request Equitable Relief to encourage prompt resolution of liability determinations. Basically, applications for relief under this provision were denied if active collections had been ongoing for more than two years.

On August 8, 2011, the IRS issued Notice 2011-70. The IRS removed the two year rule pending formal alteration of Treasury Regulations. This action was the result of several court rulings that questioned the validity of the provision.

This action by the IRS is important because a somewhat arbitrary rule has now been disposed of and relief can now be granted to otherwise qualified individuals.

It is particularly interesting to note that the IRS included in Notice 2011-70 that those individuals who were previously denied relief under equitable relief provisions solely because of the two year rule, may re-apply for relief.

If you believe that you should be relieved of joint liability with your spouse or former spouse, on a tax return, please contact us. The likelihood for relief is at its highest point given current IRS rules and regulations on this topic.