Joint Tax Returns and Divorce: The "Innocent Spouse" Rule

By George H. Norton, of Counsel, Lakin · Spears, and Garrett C. Dailey, President, Attorney's Briefcase, Inc.

Reproduced from commentary in Lawgic's California Marital Settlements

Summary: Recent federal legislation has liberalized the rules under which one of the spouses filing a joint tax return may escape liability for unpaid taxes based on lack of knowledge about the other spouse’s understatement of income. However, care should still be exercised when filing a joint tax return with an estranged or recently-divorced spouse.

Internal Revenue Code section 6013(d)(3) provides: "if a joint return is made, the tax shall be computed on the aggregate income and the liability with respect to the tax shall be joint and several."

Just as the allocation of taxes in a marital settlement agreement is not binding on the Internal Revenue Service, so too, a determination that a spouse qualifies as an innocent spouse under the tax laws does not shield him or her from liability under California community property laws. If an agreement or judgment requires a spouse to pay one-half of the income tax liabilities, that order will be enforced, even if the spouse has received innocent spouse status from the IRS. (In re Marriage of Hargrave [Hargrave II] (1995) 36 Cal.App.4th 1313, 43 Cal.Rptr.2d 474.) Of course, the agreement could provide that the parties agree to accept an IRS or tax court determination of innocent spouse status as binding for allocation of income tax liability in their dissolution action as well. If this is being considered, the parties' attorneys should be certain that the innocent spouse rule is explained and that the parties understand that it is often difficult to obtain relief from it. Moreover, the test that the IRS uses, as explained below, is not necessarily one that mirrors California public policy. (See Fam. Code §§1100 et seq. [fiduciary duty].)

Under certain circumstances, the innocent spouse rule may protect a spouse who did not have knowledge of the facts that caused the understatement or, in the alternative, the amount of the understatement. In the past, these rules have been very technical and often difficult to meet. However, the Internal Revenue Service Restructuring and Reform Act of 1998 (P.L. 105-206) eased the requirements for innocent spouse relief and made it more available. Int. Rev. Code §6015 was added to provide relief from the joint and several liability rules for certain joint income tax filers. The following are the requirements:

1.   A joint return has been filed;

2. For a taxable year on which there is an understatement of tax attributable to erroneous items of one of the filers; and

3. The innocent spouse ("other individual ") filing the joint return establishes that in signing the return s/he did not know, and had no reason to know, that there was such understatement; and

4. Taking into account all the facts and circumstances, it is inequitable to hold innocent spouse liable for the deficiency in tax for such taxable year attributable to such understatement; and

5. The innocent spouse elects the benefits of this subsection not later than 2 years after the date the Secretary has begun collection activities with respect to the individual making the election,

6. Then the innocent spouse shall be relieved of liability for tax (including interest, penalties, and other amounts) for such taxable year to the extent such liability is attributable to such understatement. (Int. Rev. Code §6015 (b).)

If a taxpayer files a joint tax return and then divorces, legally separates or lives apart from his/her spouse for a year, s/he can "elect" separate liability, if s/he can prove that any tax deficiency is allocable to the ex-spouse.

Assuming the other requirements are met, the spouse seeking innocent spouse status must also establish both that he or she "did not know, and had no reason to know" of it. It is difficult to keep the IRS from imputing knowledge. In making this determination, the IRS and the tax courts will look to a reasonably prudent person test. Among the factors that will be examined are whether there were unusual and lavish expenditures, the innocent spouse's participation in the enterprise that produced the income, and his or her involvement in the family's affairs. If the spouse cannot meet this test, but otherwise qualifies for relief under the above procedure, s/he can still get some relief if s/he can establish that in signing the return s/he did not know, and had no reason to know, the extent of such understatement. If so, then s/he shall be relieved of liability for tax (including interest, penalties, and other amounts) for such taxable year to the extent that such liability is attributable to the portion of such understatement of which s/he did not know and had no reason to know. (Int.Rev. Code §6015 (b)(2).)

In general, the "innocent spouse" is only responsible for his/her pro rata share of the deficiency. Items giving rise to a deficiency on a joint return are to be allocated to the individuals filing the return in the same manner as they would have been allocated if the individuals had filed separate returns for the taxable year, unless both spouses received a tax benefit from the item or there was fraud. If the liability of a child of a taxpayer is included on a joint return, such liability is to be disregarded in computing the separate liability of either spouse and such liability shall be allocated appropriately between the spouses. (Int.Rev. Code §6015 (d).)

Although a determination of whether the innocent spouse rule applies is often subjective and highly fact specific, generally, innocent spouse relief is available if the noninnocent spouse used the omitted income to: (1) gamble with or pay gambling debts; (2) support extramarital affairs; (3) benefit third parties; (4) purchase assets, which he or she holds separately; (5) maintain separate banking accounts; or (6) support a life style that is not enjoyed by the innocent spouse.

These rules are highly technical and require the advice of an expert accountant or attorney familiar with their application by the internal revenue service and the tax court. A family law attorney who does not have this expertise must seek the advice of such an expert prior to advising a client as to whether he or she qualifies as an innocent spouse.

Generally, in the past, the innocent spouse rule has been mechanically applied. Either a spouse qualified or he or she did not. Usually, one was not a little bit innocent. However, Wiksell v. I.R.S. (9th Cir. 1996) 90 F.3d 1459, softened the harsh application of this rule. In Wiksell, the Ninth Circuit Court of Appeals held that a spouse could be held innocent as to that portion of the substantial understatement he or she did not, and had no reason to know, about. Thus, if a spouse had reason to know of 10% of the understatement, he or she could get innocent spouse treatment as to the other 90%. However, before one can even argue for an apportionment of the deficiency, one must meet the threshold test for a "substantial understatement of tax," as set forth above. On remand, the Tax Court found that the wife qualified as an innocent spouse for income she did not know about, but not for income that passed through her hands. (Wiksell v. Commissioner (1998) TCM 1998-3, 75 T.C.M. (CCH) 1512, T.C.M. (RIA) 98,003.) Under Int.Rev. Code §6105, the allocation of liability has been made part of the statute.

The California version of this rule is somewhat different and is located at Revenue & Taxation Code section 18533. It does not contain the same threshold requirements as does the federal rule. In addition, Revenue & Taxation Code section 19006 permits the trial court in the dissolution action to revise the state tax liability between the parties (subject to certain limitations).

Conclusion: Despite the recent liberalization of the innocent spouse rule, don't count on having the protection of the rule when you sign a joint tax return, or a marital settlement.