Liability Relief on Joint Returns
Although most married couples benefit from filing a joint tax return, the spouses are held jointly liable for the entire tax, including penalties and interest. When a spouse either fills out the information for the return or provides the information to a tax preparer, the other spouse may not know about mistakes in the information or about an attempt to evade taxes by the reporting spouse. This is especially true if the couple become separated or divorced, or if a spouse is abandoned by the other. Nonetheless, under IRC § 6013(d)(3), the other spouse will be held jointly liable for the underpayment or underreporting of taxes unless she can take advantage of one or more of the 4 types of relief that are available to an innocent spouse:
- innocent spouse relief
- separation of liability
- equitable relief, and
- relief from liability because of community property law
Although the requirements for relief differ according to the type of relief sought, the electing spouse requests any type of relief by filing Form 8857, Request for Innocent Spouse Relief. In all cases where relief is sought, the IRS will notify the non-electing spouse so that he can present his own case.
If the request for relief is denied, then an appeal can be filed with the tax court, which must be within 90 days from when the IRS mails a determination refusing the request for relief. If the IRS does not mail a determination within 6 months, then the taxpayer can file a petition with the tax court requesting relief. If the appeal is granted, then the non-electing spouse can file a formal protest with the IRS appeals office to dispute the granting of innocent spouse relief.
Filing a separate return is the best way to prevent joint and several liability for mistakes, misrepresentations, or omissions by a spouse and to eliminate the need to fill out the onerous and lengthy Form 8857. Otherwise, liability relief will depend on IRS determinations.
Innocent Spouse Relief
Innocent spouse relief is only available if there was an understatement of tax because the reporting spouse did not claim income, or he claimed deductions or tax credits that he was not entitled to or that were inflated.
There are several requirements that must be satisfied before being granted innocent spouse relief:
- the innocent spouse filed a joint return with the understatement of tax because of erroneous items reported by the other spouse;
- the innocent spouse had no reason to know and did not know or have reason to know, that there was an understatement of tax; and
- by considering all facts and circumstances, it would be unfair to hold the innocent spouse liable.
Form 8857, Request for Innocent Spouse Relief must be filed within 2 years when the IRS started collection activity on the unpaid taxes, such as reducing a refund or garnishing wages. After 2 years, innocent spouse relief will not be available, but equitable relief will still be available for up to 10 years after IRS collection activities are started. To request relief, you must provide details on your finances and on your involvement in preparing the joint return on Form 8857.
Crucial evidence that the IRS will consider is whether the electing spouse received any substantial benefits from the understatement of tax and whether the spouses were later divorced or separated or the innocent spouse was deserted by the other spouse. However, if the innocent spouse had actual knowledge, or if she should have known, about the understatement of tax, then innocent spouse relief will be barred. If the innocent spouse knew about some mistaken items, but not others, then she may be granted partial relief from what she did not know.
Separation of Liability
If a couple becomes legally separated or divorced, or if they no longer live together, then a spouse may request, using Form 8857, a separation of liability for any understatement of tax by the other spouse. A separation of liability request must satisfy the following requirements:
- a joint return was filed
- the joint filers are either no longer married or are legally separated, or the joint filers did not live in the same household for the year ending on the date of the filing of Form 8857, or
- the other spouse has died
A taxpayer who chooses relief under separation of liability has the burden of proving income and deductions.
Separate liability does not prevent joint liability for unpaid tax if the proper amount of taxes was reported. Under separate liability rules, income and deductions are allocated according to what they would be if the spouses had filed separately. However, if the innocent spouse benefited from any deductions, then she must pay that part of the liability by which she benefited.
For instance, if the husband had reported $10,000 of business income, his sole income, but also took a $20,000 deduction, then $10,000 of that deduction will eliminate the husband's business income and will also lower the wife's income by $10,000. Hence, the deduction benefited both spouses 50%. Therefore, if the IRS disallows the deduction, then the wife must pay 50% of the resulting tax.
A spouse will be liable for unreported income earned by the other spouse that was known to be unreported, but will not be liable for any other unreported income earned by the other spouse if she did not know about it. A spouse will also be liable for unreported income by the other spouse even if she did not know the amount that was unreported. Any deficiencies because of unreported or underreported income from a jointly owned business will be allocated according to the ownership share of each spouse. So, if the husband owns 25% of the business and the wife owns the remaining share, then 25% of any tax deficiency will be allocated to husband and 75% of the deficiency will be allocated to the wife. Likewise, the percentage of benefit that a spouse received because of overstated deductions or from the claiming of ineligible tax credits will make that spouse liable for that percentage of any tax deficiency because of the erroneous deductions or tax credits, even if she did not know about them.
Both spouses can request a separation of liability, so that each will only be liable for their share of any tax deficiency; otherwise, a spouse that does not request a separation of liability may be liable for the entire amount, even if part of the liability is attributed to the requesting spouse.
Example: Separation of Tax Liability for Unreported Income
Your spouse received $20,000 of taxable income, of which you knew $5000 was unreported, and the IRS has determined that. The IRS will 1st try to collect the entire $20,000 from your spouse, but if it fails to collect the entire amount, then they can collect up to $5000 from you.
Asset transfers between spouses may prevent a separation of liability consideration if the principal purpose of the transfer was to avoid taxes. Transfers made within 1 year before the first deficiency letter are presumed to have a tax avoidance purpose, unless the spouses are divorced or are under a decree of separate maintenance. This presumption can be rebutted by showing that the asset transfer was for another purpose, but if it is not rebutted, the value of the transferred asset may increase the liability of the innocent spouse by the value of the asset, but only if she knew that the transfer was to avoid taxes. If the innocent spouse benefited from the transfer, but did not know that the transfer was for tax avoidance, then the innocent spouse will only be liable to the extent that she benefited from the transfer.
If an innocent spouse cannot satisfy the requirements for innocent spouse relief or separation of liability, then she may still seek equitable relief, by filing Form 8857, where considering all the facts and circumstances, it would be unfair to hold the innocent spouse liable for the understatement or underpayment of tax. For instance, if the correct tax was reported, but was not paid, then the innocent spouse must request equitable relief, since this is the only form of relief available for the underpayment of tax.
To obtain equitable relief, the following conditions must be satisfied:
- a joint return was filed
- relief is not available under the entered innocent spouse or separate liability rules
- no assets were transferred to the innocent spouse for the purpose of avoiding taxes, and if so, then equitable relief will only be granted to the extent that the tax liability exceeds the value of the transferred property
- the tax liability is attributable to the other spouse
Equitable relief may still be provided even if the above rules are not satisfied, if:
- the transferred property was community property
- the innocent spouse had only nominal ownership of the property,
- the other spouse did not pay the tax for whatever reason but without the knowledge of the innocent spouse, or
- the innocent spouse did not challenge the tax return for fear of being abused by the other spouse
Previously, the request for equitable relief must have been made within 2 years of when the IRS started collecting a tax deficiency but the IRS has removed that restriction. In response to pressure from Congress and others, the IRS eliminated the 2-year rule for requesting relief on July 25, 2011 (Notice 2011-70). Now the spouse can request relief at any time during which the tax can be collected, up to 10 years after the tax has been assessed.
A streamlined determination of relief may also be granted if the spouses are no longer married, the innocent spouse would suffer economic hardship without the relief, and the innocent spouse did not know or have reason to know about the unreported or unpaid tax liability. Even if the innocent spouse did know, a streamlined determination may still be granted if the innocent spouse feared abuse, was unable to correct a joint return, or because the tax was not paid because the innocent spouse did not control the finances.
Even if the above conditions for equitable relief or streamlined relief are not satisfied, equitable relief may still be granted, according to Revenue Procedure 2013-43, if evidence indicates that the innocent spouse had no knowledge of the tax problems or could not have done anything even if she knew that the return was not correct, or if she feared abuse if she reported the problem to the IRS.
Equitable relief may even be granted to the spouse who incurred the tax liability, but where the failure to report or pay taxes on the income was attributed to the other spouse. In one court case, a business owner assumed his wife had reported and paid the tax on his income, as was their habit, but after his wife died, the business owner later discovered the income was not reported and the taxes were not paid. Consequently, he sought equitable relief from the interest assessed on the unreported income and the added tax penalties, which the IRS denied because the income was attributed to him. Nonetheless, the Tax Court granted equitable relief, given that the IRS's own guidelines, published in Revenue Procedure 2013-43, provide that equitable relief can be granted to the requesting spouse who incurred the tax liability, if the neglect or fraud was due to the other spouse. The business owner still had to pay the tax liability, but not the interest and penalties.
Relief from Liability Arising from Community Property Law
The income earned by a married couple in a community property state — Alaska (if the couple requested community property status), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin — is considered earned equally by each spouse, so even if the spouses file separate returns, they each must report ½ of the total marital income. However, if the spouses become separated or divorced, the innocent spouse may not know the income of the other. If an item of income was omitted on the separate return of a spouse who did not earn the income, then she may need to request relief from liability that arises because of community property laws.
To obtain relief:
- the couple must not have filed a joint return
- an item of gross income was not included on the return of the spouse seeking relief that was earned or due to the other spouse, and
- the electing spouse had no knowledge nor had any reason to know of the omitted income.
Injured Spouse Claims for Refund
On a joint return, the IRS may withhold certain tax refunds if a spouse did not pay child or spousal support or certain federal debts, such as student loans. However, the spouse who is not responsible for the debts can ask for a refund of her part of the overpayment if:
- she is not required to pay the past due amount;
- she received the income reported on the joint return; and
- she reported the tax payments for which a refund is due, such as withheld federal income taxes or paid estimated taxes that exceeded her tax liability, on the joint return.
To claim an injured spouse refund, the term injured spouse must be written in the upper left-hand corner of Form 1040, U.S. Individual Income Tax Return and Form 8379, Injured Spouse Allocation must be attached. If the joint return was already filed, then the non-obligated spouse should simply file Form 8379 by itself to claim a refund.
- In 2010, there were 50,149 applications for innocent spouse relief — 7683 of them were granted and 6383 were partially granted.