THE NEW “INNOCENT SPOUSE ” RULES

Sound familiar? Ever represent a client whose ex-husband invested in tax shelters or claimed erroneous deductions on a joint return without her knowledge? Or a widow left holding the bag when the IRS gets done auditing her late husband’s business?

With half of all marriages ending in divorce, there are many ex-spouses who owe insurmountable tax debts resulting from IRS audit adjustments to joint tax returns they signed during their marriages. Often one spouse takes the lead in financial and tax matters, and the other has little or no knowledge of what’s on the returns. In these situations the IRS Collection Division has shown a remarkable proclivity to attack the party who is easiest to find, while ignoring the other ex-spouse entirely. And sometimes the IRS, despite its best efforts, is unable to collect from the other ex-spouse because he or she has no assets or no income, or has discharged the tax liabilities in bankruptcy.2

Taxpayer Bill of Rights 3.

Before the Internal Revenue Service Restructuring and Reform Act of 1998, poor Scarlett might have been in deep grits. But the Taxpayer Bill of Rights 3, part of the new Act, has greatly enhanced the ability of a spouse, especially one who is widowed, divorced or separated, to escape the “joint and several liability” which normally results from the filing of a joint return. And because in the end the Congress chose to follow the Senate version of H.R. 2676 instead of the original House language, this relief is available with respect to all tax deficiencies which are unpaid as of the date of enactment, regardless of the tax year involved. Indeed, it may permit the recovery of some taxes previously paid.

The Taxpayer Bill of Rights 3 has added §6015 to the Internal Revenue Code, replacing the old IRC §6013(e) innocent spouse provisions. Two levels of relief from tax deficiencies are available: one applies to all joint filers, while the other applies only to persons who are divorced, or widowed, or who have been separated for 12 months. In narrow situations yet to be defined, relief may also available from taxes reported on joint returns but not paid if the IRS, in its administrative discretion, finds that it would be “inequitable” to hold one spouse liable.

I. Tax deficiencies

A. Relief available to all joint filers.

The relief available to all joint filers, even those who are still married, is described in new IRC §6015(b). The “innocent spouse” will be relieved of joint and several liability for a tax deficiency under the following circumstances (let’s call our taxpayers Rhett and Scarlett for the sake of clarity):

(A) Rhett and Scarlett filed a joint income tax return.

(B) On the return there was “an understatement of tax 3 attributable to erroneous items” relating only to Rhett.

(C) Scarlett establishes that she “did not know, and had no reason to know,” of the tax understatement.

(D) Scarlett convinces the IRS (or the Tax Court, more on this below) that “taking into account all the facts and circumstances, it is inequitable” to hold her liable for the understatement. 4

(E) Scarlett seeks the benefits of IRC §6015(b) in the manner prescribed by the IRS, within two years of the time the IRS begins collection action against her.

This is similar to the innocent spouse relief heretofore available under IRC §6013(e). However, several important restrictions and limitations have been eliminated.

First, under IRC §6013(e) the tax understatement had to be attributable to “grossly erroneous items.” All omissions of income met that requirement, but many disallowed deductions did not. Relief was limited to the consequences of deductions which were “wholly without basis in law or fact.” And the IRS and the Tax Court were quite miserly in construing this phrase. Most tax shelter deductions, for example, though routinely disallowed and thus giving rise to massive liabilities for taxes, penalties and interest, nevertheless did not satisfy the higher standard of “wholly without basis in law or fact.”5As a result, many ex-wives who were entirely “innocent” in the conventional sense were denied relief. The definitional complexities of “grossly erroneous items” and “wholly without basis in law or fact” have now been removed.

Second, under the old law spouses could obtain relief only if the amount involved exceeded certain limitations. First, the tax deficiency had to be more than $500. In addition, the tax, penalties and interest had to exceed certain percentages of the innocent spouse’s adjusted gross income for the year prior to the year in which relief was sought. If AGI for the prior year was $20,000 or less, the amount at issue had to exceed 10% of AGI; if AGI exceeded $20,000, the liability had to exceed 25% of such AGI to warrant relief. And most unfairly, if the innocent spouse had remarried, the AGI to be considered included that of his or her new spouse, even if they did not file a joint return! All of these dollar limitations are now gone.

The above-described changes alone would have been quite helpful to those of us who routinely represent taxpayers before the IRS Collection Division. But there is much more:

B. Relief for divorced, widowed and separated spouses.

Note that under IRC §6015(b), like the old §6013(e), Scarlett has to demonstrate that it would be “inequitable” to hold her responsible for the deficiency. Have you ever tried to convince an IRS Revenue Officer that it would be “inequitable” to collect taxes from your poor client? He’s heard it all before, and he doesn’t want to hear it again. Now, under IRC §6015(c) and (d), a divorced, widowed or separated spouse may simply elect to have his or her share of the deficiency recomputed on a “proportional” basis. In effect, the taxes are recomputed as though the spouses had filed separate returns, and they then share responsibility for the deficiency in the same proportion.6

The application of the new rules is quite simple. To have her liability for a deficiency on a previously filed joint return recomputed and apportioned under IRC §6015(c), Scarlett need only show that at the time her election is filed with the Service she and Rhett are “no longer married,” or are “legally separated,” or that they have not been members of the same household for the preceding 12 months. Scarlett must file the election7 to apportion liability for the deficiency within two years of the time the IRS begins collection action against her. Act §3201(g)(2) provides that the two year period for filing a claim for relief under either §6015(b) or (c) starts with the first collection action taken by the IRS against the taxpayer after the date of enactment.

To counter a demand for apportioning responsibility for a deficiency in the case of a divorced, widowed or separated spouse, the IRS has only a few limited arguments available to it under the new law. First, the Service can demonstrate that Scarlett is ineligible for relief because assets were transferred between her and Rhett “as part of a fraudulent scheme.” This language was included in response to the IRS’s concerns that a pure proportional liability system would be subject to manipulation and impossible to administer.8 The burden of proof to demonstrate the existence of a fraudulent asset transfer scheme rests with the IRS.

Related to this, even if the asset transfers do not constitute a fraudulent scheme, the IRS can increase Scarlett’s apportioned part of the joint return deficiency “by the value of any ‘disqualified asset’” transferred to her by Rhett. A disqualified asset is any “property or right to property transferred to an individual making the election . . . by the other individual filing such joint return if the principal purpose of the transfer was the avoidance of tax or payment of tax.” Congress, in its wisdom, included in the new law a presumption that any transfer made within one year before the issuance of a 30-day letter with regard to a proposed deficiency is such a transfer. This is a “rebuttable” presumption, which Scarlett can overcome with evidence that the transfer had some other objective as its principal purpose. Furthermore, the presumption does not apply to any transfer made pursuant to a decree of divorce or separate maintenance.

Second, the IRS can try to prove that Scarlett “had actual knowledge, at the time [she] signed the return, of any item giving rise to a deficiency. . .” Even this exception, however, does not apply where an individual who did have such actual knowledge demonstrates that he or she signed the tax return under duress. In the many such cases I have handled over the past two decades, I have been astounded at how often great emotional and even physical pressure is brought to bear on a wife to induce her to sign a joint tax return with her soon to be ex-husband.

Short of proving actual knowledge or prohibited asset transfers as outlined above, the IRS must allow the parties to recompute and apportion their liability for deficiencies on joint returns. The procedures for determining the portion of the deficiency allocable to the respective spouses are explained in IRC §6015(d). It involves the allocation of each item of income, deduction and credit between the spouses “in the same manner as it would have been allocated if the individuals had filed separate returns for the taxable year.”

II. Taxes shown on joint returns as filed

As discussed above, both the old and the new innocent spouse rules focus on tax “deficiencies,” as opposed to balances shown as due on joint returns but simply never paid. One portion of the new innocent spouse rules, however, offers at least the hope of some relief for any balances due with respect to joint returns, even when relief would not be otherwise available. Specifically, new IRC §6015(f) permits the IRS to waive “any unpaid tax or deficiency (or any portion of either),” if in light of all the facts and circumstances “it is inequitable to hold the individual liable.” The Service is directed to adopt Regulations to implement this provision for situations in which relief is not available under §6015(b) or (c).9 As an example of what it had in mind, the Report of the Conference Committee suggests that such relief should be available “to a spouse that does not know, and had no reason to know, that funds intended for the payment of tax were instead taken by the other spouse for such other spouse’s benefit.” It will be interesting to see what situations the IRS decides warrant relief from collection, and what litigation is brought by taxpayers seeking to force the IRS to exercise its new found administrative discretion.

III. Petition for review by the Tax Court

If the IRS denies a request for relief under IRC §6015(b), or an election for recomputation under IRC §6015(c), the taxpayer can have the issue decided by the Tax Court.10 The IRS is instructed to issue a 90-day letter if it denies the claimed relief, whereupon the taxpayer may file a petition. Furthermore, if the Service fails to act on a request, six months after the claim is filed the taxpayer may petition the Tax Court even in the absence of a 90-day letter. And while the innocent spouse claim is under consideration by the IRS, or by the Tax Court after the filing of a petition, the Service may not serve levies or take action in court to collect the disputed assessment from the taxpayer claiming relief. If such collection action is taken, the Service may be enjoined.

In facilitating recourse to the Tax Court, the new law removes a major obstacle which has prevented many spouses, widows and divorced wives from ever having their day in court. In law there is a rule of judicial finality known as res judicata, or “a thing decided.” The IRS has routinely raised this as a defense to innocent spouse claims where the tax deficiency in question resulted from earlier litigation in the Tax Court.

Far too often in such litigation, however, or in the preliminary Appeals Office negotiations where the majority of such cases are settled, lawyers have focused on the businessman or professional husband involved in the dispute, and completely ignored the separate interests of the wife. And while both spouses were technically parties because a joint return was filed, the wife had little or no involvement in any aspect of the case. Indeed, often the spouses were divorced before the audit adjustments were proposed, or before the matter was settled or litigated. And usually the first time anyone even thought of the separate legal interests of the wife was when Attila the Revenue Officer showed up to carry off her car, her bank account, her furniture, and anything else that wasn’t nailed down.

Thankfully, new IRC §6015(e)(3)(B) has solved this problem. It provides that even if a decision of the Tax Court has become final in a case involving the same tax year, this will not serve as a bar “with respect to the qualification of the individual for relief which was not an issue in such proceeding.” The only exception is if the Court finds that the claimant “participated meaningfully” in the prior case. Thus, if in the typical case no one bothered to raise the innocent spouse issue on the wife’s behalf in Appeals or in the Tax Court, she will no longer be estopped from raising it as a defense to levy and distraint action being taken against her by the Collection Division.11

IV. Conclusion

As stated at the top of this article, H.R. 2676 as proposed by the House would have offered protection only against deficiencies assessed in the future, for tax years beginning after the date of enactment. It would have done absolutely nothing for thousands of taxpayers, mostly divorced and widowed women, who are already dealing with the tax collector because of problems caused by their former spouses. The Senate took a different approach, based on proportional liability for all tax liabilities, and covering all taxes remaining unpaid on the date of enactment regardless of the tax year involved. The final legislative compromise applies the proportional liability approach only to deficiencies, while holding out at least some hope for discretionary equitable relief from other joint return liabilities. Most importantly, the law follows the Senate bill in reaching all unpaid taxes, not just taxes assessed in the future.

All of this gives us as tax professionals the chance to assist those for whom the disruptions attendant to the loss of a spouse through separation, divorce or death are exacerbated by burdensome tax liabilities resulting from joint returns filed during the marriage. In the past many of these situations were beyond repair. But thanks to the new innocent spouse provisions of the Taxpayer Bill of Rights 3, that may no longer be the case. We should be alert for opportunities to help our clients obtain the relief to which they may now be entitled.