When Is A Spouse An Innocent Spouse?

The privilege of filing a joint individual income tax return carries with it the obligation for each spouse of joint and several liability for the tax, interest, and penalties. In most divorce agreements, one spouse indemnifies the other against tax claims arising from joint returns. Unfortunately, such indemnifications do not prevent the IRS from collecting tax deficiencies from either or both of the spouses who filed the joint return. If the indemnifying spouse does not have the financial resources to pay the taxes, the indemnified spouse may be faced with paying all or a portion of the joint tax liability. In some circumstances however, one spouse has merely signed the return and has no knowledge of false deductions or intentional understatements of income by the other spouse. Internal Revenue Code Section 6013(e) was enacted to provide relief to the innocent spouse in situations where the result of joint and several liability is inequitable.

Innocent Spouse Requirements

A spouse may be relieved of liability for tax resulting from a joint return when:

1) there is a substantial understatement of tax attributable to grossly erroneous items of one spouse;

2) the other spouse establishes that in signing the return, he/she did not know and had no reason to know that there was a substantial understatement; and

3) taking into account all of the factors and circumstances, it is inequitable to hold the spouse liable for the deficiency attributable to the substantial understatement.

Failure to establish any one of these requirements will prevent a spouse from qualifying for relief.

Substantial Understatement Attributable to Grossly Erroneous Items

For purposes of the innocent spouse rule, a substantial understatement is any understatement which exceeds $500. There are two types of grossly erroneous items:

1) Omitted income ¾ Any item of gross income attributable to the other spouse which was omitted from the joint return, and

2) Erroneous deductions ¾ Any claim of a deduction or credit by the spouse in an amount for which there is no basis in fact or law.

Relief is available for erroneous deductions only if the tax liability exceeds a specific percentage of the innocent spouse’s adjusted gross income for the tax year immediately preceding the date the deficiency notice was mailed. If the spouse’s adjusted gross income is $20,000 or less, the tax liability must exceed 10 percent of adjusted gross income in order for the innocent spouse rule to apply. If the spouses’ adjusted gross income is more than $20,000, relief is available only if the liability is greater than 25 percent of adjusted gross income.

If the spouse is married to another spouse at the end of the tax year prior to the date of the deficiency notice, the spouse’s adjusted gross income includes the income of the new spouse whether or not they file a joint return.

A deduction has no basis in fact when the expense for which the deduction was claimed was never, in fact, made or when the expense, even if made, does not qualify as a deductible expense under well-settled legal principles. Relief may be denied where there is some basis to support the credit or deduction.

Lack of Knowledge

With respect to the lack of knowledge requirement, the courts make distinctions between cases involving omissions from income and cases involving erroneous deductions. In omissions cases, the spouse must establish that he/she did not know of the transaction producing the income omitted from the return to obtain relief. In erroneous deduction cases, knowledge of the transaction by itself does not preclude relief. The spouse need only establish that he/she had no reason to know the tax liability as stated was erroneous at the time the return was signed or that further investigation was warranted.

Among the factors considered in determining whether a spouse has a reason to know or a duty to inquire are:

1) the spouse’s level of education;

2) the spouse’s involvement in the family’s business and financial affairs;

3) the presence of a lifestyle that is inconsistent with the sources and amounts of income reported on the return; and

4) the culpable spouse’s evasiveness and deceit concerning the couple’s finances.

If a spouse has previously questioned the other spouse about a transaction or deduction and received assurances about their legitimacy, the tax court has held that additional inquiry when presented with the return is not required unless it arrives with a “red flag” such as the omission of the preparer’s signature.

Inequitable to Hold Spouse Liable

There are several factors which are taken into account in determining whether it is inequitable to hold a spouse liable for a tax deficiency:

1) Whether or not the innocent spouse received a significant benefit from the unreported income or erroneous deduction.

2) Marital status of the innocent spouse.

3) Whether the innocent spouse participated in the financial affairs of the parties.

4) Whether or not funds set aside by the spouses for potential tax liabilities have been spent on other items.

Normal support is not a “significant benefit” for purposes of determining whether it is inequitable to hold a spouse liable for a deficiency. A significant benefit may be evidenced by the transfer of property (for example, when a spouse receives an inheritance or life insurance proceeds which are traceable to the omitted items).

Whether the innocent spouse has been deserted or divorced or separated is taken into account in determining if it is inequitable to hold the spouse liable for the taxes.

If the spouse seeking innocent spouse treatment participates in the financial affairs of the other spouse and enjoys the benefits of the other spouse’s activities, innocent spouse relief will not be granted.

The innocent spouse rules were not designed to compensate one spouse for the other spouse’s failure to make payments of another kind. For example, a taxpayer’s divorce decree recognized a potential tax liability and funds were escrowed to meet it. When these funds were released to the taxpayer, she used them for personal purposes and was not allowed innocent spouse relief when the tax liability became due.