Let’s suppose that you file a joint income tax return with your spouse in 2008. Not an uncommon occurrence, millions of couples do so every year. But from there, things go downhill and the two of you divorce two years later. Thinking that the divorce and its financial ramifications are behind you, you start to move on. Then one day you get a letter from your favorite Uncle Sam. The IRS has just notified you that your income for that 2008 return you filed was grossly underreported and that you have a $50,000 tax obligation. To make matters worse, you have no idea where your ex-spouse is and the IRS doesn’t know either.
As it turns out, your spouse was a compulsive gambler, unknown to you. In 2008 there were significant gambling winnings that 1) you did not know about and 2) were not reported on the joint tax return. When you signed that return, you affirmed that it was “to the best of your knowledge true, correct, and complete.” Since you signed it, you can be held fully responsible for the accuracy of the return as well as the payment of tax. But you say “Wait a minute! It says to the best of my knowledge. I did not know anything about this.” To which the IRS will say “Prove it.”
Fear not. TaxDoc, CPA is here. You may be eligible for innocent spouse relief and you may escape having to pay this huge liability, even if no one can find your ex. There are three types of innocent spouse relief:
- Traditional innocent spouse relief
- Separate liability election, and
- Equitable relief.
To request relief under any of these types, you should file Form 8857, Request for Innocent Spouse Relief. Let’s look at each of these methods to help you determine the best route for you to take (other than the route to Togo, which has no extradition treaty with the United States). Take note that an innocent spouse and an injured spouse are two separate, distinct tax doctrines. An injured spouse is a topic for another day.
Traditional Innocent Spouse Relief
Under traditional relief, as with all three methods, the filing status must be married filing jointly. The traditional approach can be utilized regardless of your present marital status.
There must be an understatement of tax due to an erroneous item attributable to the other spouse and the taxpayer did not know and had no reason to know of the understatement when signing the return. Suppose the other spouse had some gambling or other income that was not reported on the return. The taxpayer had no knowledge of this income. Note, however, that the requirement goes further – “had no reason to know.” The IRS test for this considers factors such as the taxpayer’s education level, experience and knowledge in the family’s finances, changes in family lifestyle, unusual or lavish expenditures, evasiveness or deceit on the part of the spouse, and if the taxpayer made reasonable inquiry about items on the return.
The traditional method is available without regard to whether the amount in question has been paid or not. If it has been paid, the taxpayer will receive a refund if the request is granted. The key to having the innocent spouse request approved under this method is “unfairness.” If the IRS deems that is it unfair to hold the taxpayer liable for the understatement considering all facts and circumstances of the case, relief will likely be granted.
Separate Liability Election
Under the separate liability election, the spouses must no longer be married, be legally separated, or have lived apart for at least 12 months. There must be an understatement of the tax due to an item allocable to the other spouse. If the tax in question has been paid, a separate liability election cannot be made.
The standard for knowledge under this approach is less strict, stating merely that the taxpayer did not have actual knowledge of one or more of the erroneous items. If a separate liability election is granted, the IRS will allocate income and deductions to the husband and wife, each being responsible for their share of the tax liability.
Under equitable relief the basic requirement is that circumstances make the taxpayer’s liability inequitable. Factors such as divorce, taxpayer hardship, abuse by the other spouse, or a divorce decree requiring the other spouse to pay the tax are taken into consideration in granting equitable relief. However, there are also factors working against the taxpayer – the error attributable to the taxpayer, knowledge or reason to know of the deficiency, benefiting from the unpaid tax, or a divorce decree requiring the taxpayer to pay the tax.
The basic criterion is unfairness as stated under the traditional relief method. However, equitable relief is available only if the taxpayer does not qualify for tradition or separate liability relief.
Under all the methods the IRS is required to notify the spouse or former spouse and allow him/her to participate in the determination of the amount of relief.
Any request for relief must have been made within two years of the first IRS collection activity. This is written into the IRS code for the traditional and separate liability elections methods. IRS rules have also limited equitable relief to the two-year window.
This rule, however, has recently been relaxed under Notice 2011-70, allowing a taxpayer to file for equitable relief as long as the period for the collection of taxes remains open for the tax years at issue. If a prior claim for equitable relief has been denied due to the two-year rule, a taxpayer can re-apply for equitable relief.
In an ideal world, we would not have a need for innocent spouse relief. Unfortunately, we do not live in such an ideal world, so mechanisms are in place to try and assure fairness for all involved.