Are tax indemnity payments to an ex-spouse taxable?

• Author: Wood, Robert W.

Tax indemnity payments are common features of many transactions, such as litigation settlement agreements, merger documents, purchase and sale agreements, leases, etc. Regardless of the context, they generally provide that if one party is taxed as a result of the transaction, the other party will reimburse the tax paid. Sometimes, indemnity provisions are part of a divorce settlement.

Why include a tax indemnity provision in a divorce settlement? Because filing a joint return results in joint and several liability (i.e., each spouse is potentially liable for the entire amount of any tax deficiencies, interest and penalties); see Sec. 6013(d)(3); Hayman, 992 F2d 1256 (2d Cir. 1993), aff'g TC Memo 1992-228; Osborn, TC Memo 1993-312.

Innocent Spouse Relief?

While a tax indemnity agreement might help an ex-spouse recover unexpected tax liabilities from the other ex-spouse, will it help the former avoid joint and several liability in the first place? No; see, e.g., Buchine, TC Memo 1992-36. While there are other ways to avoid it, the most popular method is Sec. 6015(b) innocent spouse relief.

Qualifying as an innocent spouse is not easy, however. The spouse requesting such relief must prove all of the following: (1) there is an understatement of tax attributable to erroneous income items that belong to the other spouse (or former spouse); (2) he or she was unaware of this understatement when signing the return; (3) based on all the facts and circumstances, it would be inequitable to hold the requesting spouse liable for the deficiency; and (4) he or she sought relief within two years of the IRS's commencement of collection activities; see Bokum, 94 TC 126 (1990), aff'd, 992 F2d 1132 (11th Cir. 1993).

A requesting spouse who fails to fulfill any of the above requirements is barred from qualifying as an innocent spouse under Sec. 6015(b); see Shea, 780 F2d 561 (6th Cir. 1986), aff'g in part and rev'g in part TC Memo 1984-310; Est. of Jackson, 72 TC 356 (1979). The Tax Court has frequently been unsympathetic to the plight of alleged innocent spouses; see, e.g., Stiteler, TC Memo 1995-279, aff'd w/o pub. op., 108 F3d 339 (9th Cir. 1997); Knapp, TC Memo 1988-109.

Tax on Tax?

What if an ex-spouse receives a tax bill from the IRS and the other ex-spouse indemnifies him or her for it? How is the indemnity payment treated for tax purposes? Can the reimbursing ex-spouse just write the taxed spouse a check for the gross amount? Does the check have to be...