Wednesday, August 21, 2013

Change In Innocent Spouse Tax Relief

You may have read or seen that the IRS has ‘changed” the rules for innocent spouse relief. 

While this is not wrong, it is incomplete. How? Because there are three ways to request innocent spouse status, and the IRS has changed one of them. The other two remain as they were before.

Being married and filing a joint tax return with your spouse is what creates this issue. You later divorce or separate from your spouse. You and your (now ex) spouse are audited by the IRS. Remember, the IRS lags a year or two before they select returns for audit. The IRS finds unreported income and assesses additional tax.  The income triggering the tax belongs to your ex-spouse.

Let’s return to the joint tax return you filed. A joint return means that you are “jointly and severally liable.”  The IRS can proceed against you alone, against your spouse alone or against the two of you.  The IRS can, and likely will, proceed against you (for at least 50%) even if it wasn’t your fault. From their perspective, why not? They have nothing to lose, and it doubles their chance of getting someone to pay.

This is the point of innocent spouse relief. You want to separate your tax from that of your ex-spouse. Ideally, you want to completely separate your tax, so that the IRS leaves you alone for any additional tax, penalties and interest.

There are three types of innocent spouse relief.

Type I is “general” relief:

(1)   You filed a joint return.
(2)   The return has an “understatement of tax” due to “erroneous” items of your spouse (or ex-spouse).
(3)   You can show that at the time you signed the joint return you did not know, and had no reason to know, that there was an understatement of tax.
(4)   Considering all the “facts and circumstances,” it would be unfair to hold you liable for the understatement of tax.

An “erroneous” item is IRS-speak for not reporting income or for overstating deductions.

The third requirement can be a tough to meet.  It is possible that you did not know, but that is not enough. The IRS wants to be sure that you had no reason to know. For example, you and your spouse reported $60,000 of income. That year you and your spouse bought a Colorado chalet and a Bugatti Veyron. Unless you had savings to tap into or one of you inherited, expect the IRS to be very skeptical of you denying any “knowledge.” They will figure that you should have known.  And it doesn’t have to be as dramatic as a Swiss chalet. Perhaps you and your ex moved to a nicer neighborhood. Or enrolled the kids in a private school. Or started showing horses.  A quick review of your income and savings would prompt one to wonder how you paid for everything. Expect the IRS to argue that you had “constructive” knowledge. That is, you “had reason to know.”

Type II is “separation of liability.”

Under this method, you separate your income and deductions from your (ex) spouse’s income and deductions. You then calculate your separate tax on such separate income. You are trying to get the IRS to agree that your share of the joint tax is that amount and not more.

It does have the advantage of appearing “fair.”

Oh, the IRS requires that you be divorced, legally separated or at least living apart for the 12-month period preceding the innocent spouse filing. Don’t be surprised if your tax planning includes advice to get divorced.

What is going to sour the IRS on this deal, other than their general reluctance to let anyone off the hook?  Well, that “knowledge” requirement we discussed previously will derail you, with one important distinction: you must have actually known of the tax understatement. The “you should have known” argument is not good enough to deny you the second type of innocent spouse relief.

A second thing that will sink the separation of liabilities is transferring assets for the main purpose of avoiding payment of tax. You can expect the IRS to want to review every significant asset move between you and your ex.

You must request Type I and Type II innocent spouse relief within 2 years after the date on which the IRS first begins collection activity against you. This is not the same as the date you filed the return. Rather it is the date that the IRS sends you a letter or asks you to go downtown for a meeting.

Type III is “equitable relief.”

Equitable relief is only available if you meet the following conditions:
  • You do not qualify for innocent spouse relief or separation of liability.
  • The IRS determines that it is unfair to hold you liable for the understatement of tax taking into account all the facts and circumstances.
Well, unfair is in the eye of the beholder, isn’t it? What facts and circumstances will the IRS consider as they ponder whether to be fair or unfair?
  • Current marital status
  • Abuse
  • Reasonable belief of the spouse requesting innocent spouse, at the time he or she signed the return, that the tax was going to be paid; or in the case of an understatement, whether that  spouse had knowledge or reason to know of the understatement
  • Current financial hardship or inability to pay basic living expenses
  • Legal obligation to pay the tax liability pursuant to a divorce decree or other agreement to pay the liability
  • To whom the liability is attributable
  • Significant benefit received by the spouse asking for innocent spouse
  • Mental or physical health of the spouse requesting innocent spouse on the date that spouse signed the return or requested relief
  • Compliance with income tax laws following the taxable year or years to which the request for relief relates
The IRS had previously held Type III relief to the same time limit as Types I and II. While not in the Code itself, the IRS inserted the time limit into its Regulations and battled hard to have the courts accept its position.

The IRS lost a high profile case (Lantz) on this issue in 2010. Lantz was the former wife of an Indiana dentist. In 2000 her then-husband was arrested for Medicaid fraud. Shortly thereafter came a $900,000 IRS bill. She didn’t file for innocent spouse because he told her that he had taken care of it. He did not, of course. Shortly thereafter he died.

And of course more than two years had gone by…

Mrs. Lantz filed for Type III innocent spouse. In 2009 the Tax Court sided with her. In 2010, however, the Appeals Court sided with the IRS.

The IRS Taxpayer Advocate howled at what was happening to Mrs. Lantz. Forty-nine members of the House of Representatives sent a letter to the IRS Commissioner demanding a stop to such behavior.  

The IRS did, and in 2011 it announced that it was backing-off the two-year requirement for Type III innocent spouse claims. 

The IRS has now published Regulations formalizing what it announced back in 2011.   

So how long do you have now to file a Type III innocent spouse claim? You have ten years – the same period as the IRS has to collect taxes from you.

Note though that Type I and Type II still have the two-year requirement. It is only Type III that has changed. Why the difference? Because for Types I and II, the two-year requirement is written into the law.

My Thoughts: To hold an innocent spouse to a two-year window – when the law passed by Congress said nothing about a two-year window for Type III relief – was a clubfooted mistake by the IRS. It is a bit late, but the IRS finally got it right.

By the way, if you have been turned down for innocent spouse – and you are still within the ten-year window – please consider filing again under the new rules.

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