It is always good advice for anyone signing a tax return to do so only after carefully reviewing and understanding every line of it. But even such common sense measures cannot always prevent mistakes and/or deception from happening. To avoid unfairness in such circumstances, the Tax Code has provisions designed to protect “the innocent spouse.”
Under this general heading, there are three kinds of relief: innocent spouse relief, relief by separation of liability, and equitable relief. To request relief, a taxpayer must file the appropriate form with the IRS no later than two years after the IRS first tries to collect the tax. An attached statement must explain why the taxpayer believes he or she qualifies for relief. If the IRS rejects the claims for the first two types of relief, it will automatically determine whether equitable relief is warranted.
Conditions for Relief
An innocent spouse must meet the following conditions to qualify for relief:
- a joint return understated taxes because of erroneous claims by the requesting party’s spouse, such as unreported or underreported income, or unjustified deductions or credits;
- when the return was signed, the innocent spouse did not know, or have reason to know, that there was an understatement of tax. If the spouse knew, or should have known, that there was an understatement but did not know by what amount, partial relief may be given; and
- in light of all of the surrounding circumstances, it would be unfair to hold the requesting party liable for the understatement of tax. Among the factors taken into account by the IRS are whether the taxpayer benefited from the erroneous return in the form of a higher standard of living and whether the joint filers later were divorced or separated.
A claim for innocent spouse relief was recently rejected by the Tax Court under circumstances that illustrate some of the factors that weigh against such relief. A husband underreported the income from a family business that, during the relevant tax year, was the couple’s only source of income. His wife, who had retired from another job, helped run the business in a variety of ways, including answering the telephone, sending out mail, paying hired help, and sometimes working on some of the casino game nights that the business provided for customers.
Although both spouses thought of the business as primarily being the husband’s, and only the husband had filed the joint tax return (although the wife had also signed it), the wife was too closely involved in running the business and had too much access to the records of the business to be accorded the status of an “innocent spouse.”
Relief by Separation of Liability
Separation of liability means an allocation between the spouses of unpaid liabilities resulting from the understatement of taxes owed. Either of the following requirements must be met: The parties filing the joint return are no longer married or are legally separated, or the joint filers were not members of the same household at any time during the 12 month period before the relief is sought. This relief is not available if the spouses transfer assets between themselves to avoid taxes or as part of a fraudulent scheme. Another disqualifying factor is actual knowledge of the other spouse’s erroneous items on a return that gave rise to the deficiency.
As a last resort, equitable relief may be available when there has not been any fraud and when, all things considered, it would be unfair to hold the spouse seeking relief liable for the understatement or underpayment of tax. A broad range of “fairness” factors may be considered by the IRS. There is no exhaustive list, but some examples include separation or divorce, economic hardship if relief is not granted, and the fact that the tax for which relief is sought is attributable to the other spouse.
Weighing against equitable relief would be factors such as knowledge of the items causing the understated tax, receiving a significant benefit from that understatement, or not making a good faith effort to comply with federal income tax laws for the tax year in question.