Is Your Client an "Innocent Spouse?"

by Scott E. Vincent
Shughart, Thomson & Kilroy, Kansas City

Innocent spouse relief from federal tax liabilities has been one of the hottest issues before the IRS since passage of the Internal Revenue Service Restructuring and Reform Act of 1998 (the "1998 act"), which generally broadened the relief available to spouses filing joint tax returns. Since the 1998 legislation, many practitioners are submitting innocent spouse claims in every spousal situation involving tax liabilities, which has resulted in thousands of these claims being filed. The IRS has attempted to handle this increased volume, but time delays have been significant. Unfortunately, a large proportion of these claims are being rejected by the IRS, often due to the technical rules and procedural requirements relating to these issues. In order to avoid IRS rejection and procedural delays, several key issues should be considered in evaluating spousal liability situations, including whether the spouse has liability for the taxes in question and whether one or more of the relief provisions may apply.

Joint Tax Return

Many spouses are not even liable for the taxes in question. Each spouse properly signing a joint tax return does have joint and several liability for the full tax due on the return, and the IRS generally assumes that both spouses whose names appear on a joint return are fully liable. However, some courts have held that the taxpayers' intent should govern whether a joint return has been filed.

All of the facts and circumstances are considered in analyzing taxpayer intent relating to submission of "joint" tax returns. Some courts also apply a "tacit consent" analysis in this context, which may even result in nonsigning spouses having joint liability in cases where they rely on the other spouse to handle their tax matters and do not object to joint returns filed on their behalf. Returns can also be considered joint if both spouses intend to get the benefits and burdens of joint return status. On the other hand, signatures acquired through duress, fraud or misrepresentation, as well as forged and unauthorized signatures, do not reflect intent to file joint returns.

If the "joint return" analysis indicates an individual does not have liability, these facts should be demonstrated to the IRS. If joint liability exists (or may exist), the spousal relief alternatives below should be considered.

Innocent Spouse Relief

The innocent spouse procedures allow an individual to seek relief from joint and several liability for the taxes owed on a joint return. There are several requirements for innocent spouse relief:

  1. A joint return was filed for the tax year;

  2. There is an understatement of tax on the return that is attributable to erroneous items of the other spouse;

  3. The innocent spouse establishes that he or she did not know and had no reason to know of the understatement in signing the return;

  4. It would be inequitable to hold the innocent spouse liable for the deficiency taking into account all the facts and circumstances; and

  5. The innocent spouse elects relief in the form the IRS prescribes no later than two years after the IRS has begun collection activities with respect to that spouse.

Not surprisingly, there is significant case law regarding several of these innocent spouse requirements, particularly with respect to the knowledge requirements and the "equity" issues, which are highly factual. The IRS can be expected to challenge all elements required for relief, so each of these requirements should be carefully considered in evaluating the possible success of an innocent spouse claim.

Separate Liability Election for Divorced and Separated Spouses

Individuals who are divorced, legally separated, widowed or living apart for more than 12 months may elect to limit liabilities allocable to their portion of a joint return deficiency. This "separate liability election" does not apply to spouses with actual knowledge of deficiency-creating items of the other spouse. The election applies to income and self-employment taxes, as well as alternative minimum taxes, but it does not apply to FICA tax liability.

The separate liability election can be made by each spouse with respect to the same joint return and can also be made by a spouse previously denied regular innocent spouse relief. In addition, this election does not appear to cause any detriment to the filing spouse. Therefore, the election should be considered for any clients who have filed joint returns and are divorced, legally separated, or living apart for the required period from the spouse with whom the joint return was filed.

Equitable Relief

Even if a taxpayer does not qualify for innocent spouse relief or the separate liability election, the IRS can relieve the taxpayer of liability if it would be inequitable to hold the taxpayer liable. This "equitable relief" only applies to tax liabilities shown on the return before any adjustments, and is only available to the extent the unpaid tax is not attributable to the spouse requesting relief. In addition, the IRS requires that an individual meet all of the following threshold requirements for equitable relief:

  1. The individual must have filed a joint return for the tax year for which relief is sought;

  2. The individual must not be eligible for relief under the innocent spouse or separate liability election rules;

  3. The individual must apply for equitable relief no later than two years after the IRS's first collection activity after July 22, 1998 with respect to that individual;

  4. The tax liability must be unpaid when the relief is requested, except that an individual may be eligible for a refund of liabilities paid in certain narrow circumstances;

  5. The individual and their spouse must not have transferred assets to each other as part of a fraudulent scheme; and

  6. The individual must not have filed the joint return with fraudulent intent.

Individuals who satisfy these threshold requirements may be granted equitable relief by the IRS. This relief is ordinarily granted in situations where joint return liabilities remain unpaid, the parties are no longer married or have been legally separated, the individual in question reasonably believed that the tax would be paid by their spouse, and the individual would suffer economic hardship if the relief is not granted. "Economic hardship" is generally interpreted in this context to mean the taxpayer would be unable to pay reasonable basic living expenses, as determined by the IRS.

Despite the variety of threshold requirements and the highly factual nature of the IRS analysis in this context, equitable relief should be considered as an alternative in any situations where innocent spouse relief or the separate liability election rules do not apply.

Application for Relief

IRS Form 8857, "Request for Innocent Spouse Relief (and Separation of Liability and Equitable Relief)," should be used to request the different forms of spousal relief. More than one type of relief, and relief for multiple tax years, may be requested on one Form 8857. As previously noted, these requests for relief must be made no later than two years after the IRS begins collection activity with respect to the individual in question.

Tax Court Review

The United States Tax Court has jurisdiction to review IRS denials of innocent spouse claims and separate liability elections. The Tax Court has also held (over IRS objections) that it has jurisdiction to review IRS denials of equitable relief. In order to preserve all possible arguments before the Tax Court, specific requests for innocent spouse relief, a separate liability election and equitable relief should be considered.

Conclusion

The overlap of these provisions has caused the IRS to receive many requests for spousal relief in recent years, and significant numbers of procedurally valid requests are apparently being granted. You may want to consider requesting relief for your clients as well.

JOURNAL OF THE MISSOURI BAR
Volume 56 - No. 4 - July-August 2000