Innocent spouse relief: liberalization of the lack of knowledge requirement.

AuthorZimmerman, John C.

Sec. 6013(d)(3) provides that "if a joint return is made, the tax shall be computed on the aggregate income and the liability with respect to the tax shall be joint and several. "Thus, the IRS can assess the full amount of the tax against both spouses together or either spouse individually, regardless of who actually generated the income.

Example 1: H and W, husband and wife, file a joint return. H neglects to report $20,000 of income he earned and $10,000 of income generated from his separate investment property. The tax deficiency from the $30,000 omission is $9,300. The IRS could assess the tax against both spouses or either spouse. If H has no assets to pay the tax, the IRS can assess the full amount against W.

This example illustrates how Sec. 6013(d)(3) can reach a nonoffending spouse for the deficiency of a guilty one. The section applies equally to community property and separate property states. Consequently, attribution of income from one spouse to another can be made for purposes of Sec. 6013(d)(3) in noncommunity property states.

The IRS can use its discretion as to which spouse it seeks to assess the tax against.(1) Moreover, the Service does not have to take into account the separate taxable income of each spouse when determining against whom to assess the tax.(2) Therefore, in Example 1, the full amount of tax could be assessed against the wife even if she had no income. The Service might do this if the wife had enough property to cover the deficiency and the husband had no assets that could be reached. Normally, however, the IRS will seek contribution from both spouses.

As can be seen, Sec. 6013(d)(3) can produce harsh results. However, joint and several liability is the price that must be paid for the tax advantage of filing a joint return. This article will illustrate that these unfavorable (and unfair) tax consequences can be avoided if the spouse seeking relief can show that she(3) is an innocent spouse. When the innocent spouse rules are met there is no joint or several liability. Rather, the full amount of the understated tax must be sought from the offending spouse. In Example 1, if the wife qualified as an innocent spouse, the $9,300 could be assessed only against the husband. Even when the understatement resulted from the sale of property belonging to the marital community, a spouse was able to obtain relief when she could show that her husband had complete control over the funds.(4)

It is important to note that innocent spouse relief is allowed only on the items that give rise to the tax understatement. Relief will not apply to nonunderstatement items.

Example 2: H and W, husband and wife, file a joint return. The return shows $100,000 of taxable income and a liability of $24,115 (1991 joint return rates). All of the income arises either from H's earnings or from his separate investment property. Only $14,115 of the tax has been paid when the joint return is filed and H fails to remit $10,000 with the tax return. A subsequent audit of the tax return discloses that H omitted $20,000 of his income. An additional $6,200 of tax is generated, exclusive of interest and penalties.

If W qualifies for relief as an innocent spouse, she can do so only for the $6,200 attributable to the omitted income. She will still be jointly and severally liable for amounts reported on the tax return and can be assessed for all or part of the $10,000 H failed to remit.

Sec. 6013(e)(5) applies the innocent spouse rules without regard to community property laws. Thus, a culpable spouse is separately liable for the entire community income earned by him and not reported on the tax return.

The Innocent Spouse Rules

The innocent spouse provisions of Sec. 6013(e) were enacted in 1971 and revised by the Deficit Reduction Act of 1984 (DRA). They allow a spouse to escape the tax consequences that may arise when the other spouse is solely responsible for a tax deficiency resulting from certain "erroneous items."

Four requirements must be met under Sec. 6013(e)(1) for a spouse to obtain relief. 1. A joint income tax return must be filed. 2. There must be a substantial understatement of tax attributable to grossly erroneous items of one spouse. 3. The spouse claiming relief must establish that in signing the return she did not know, and had no reason to know, of the substantial understatement. 4. Taking into account all of the facts and circumstances, it would be inequitable to hold the spouse seeking relief liable for the deficiency. The general measuring stick to determine such inequity has been the degree to which the spouse seeking relief benefited from the substantial understatement.(5)

For purposes of requirement 2, Sec. 6013(e)(2) defines a grossly erroneous item as any item of gross income attributable to an omission from gross income, and any claim for a deduction, credit or basis for which there is no basis in fact or law. If the understatement is from a gross income omission, it is only necessary for the tax that results from the omission to exceed $500.(6) However, if the understatement results from a claim of deduction, credit or basis for which there is no basis in fact or law, other requirements must be met - as defined in Sec. 6013(e)(4).(7)

It should be emphasized that all four requirements must be met for innocent spouse relief. Failing any of the four will result in disallowance of relief.(8) Also, the burden of proof is on the spouse claiming relief to prove each element.(9)

Lack of Knowledge Requirement

One commentator has noted that "[n]ot only is knowledge the most frequently litigated element of [the innocent spouse provisions], but it is often the crucial requirement upon which the fate of the spouse seeking relief rests."(10) Sec. 6013(e)(1)(c) provides that not only must the spouse seeking relief have no knowledge of the substantial understatement but also "had no reason to know. "Thus, a spouse could be liable under this section even without actual knowledge.

A recent case addressed the issue of whether a spouse who is knowledgeable about some of the income omitted on the tax return can be denied relief for that portion of which she was unaware. In Krause,(11) because the wife knew of "some" of the husband's embezzlement activities, the Tax Court found this amount of knowledge sufficient to deny innocent spouse relief for all amounts involved.

Lacking knowledge of the tax consequences of a substantial understatement will not satisfy the test. Rather, the taxpayer must show lack of knowledge of the transactions that gave rise to the understatement.(12) A taxpayer is presumed to have knowledge of the tax consequences, but not presumed to have knowledge of the transaction itself.(13) Thus, in a recent case in which the spouse was informed of her husband's embezzlement activities, the court rejected the argument that she should be afforded relief because she was unaware of the tax consequences of embezzlement.(14)

Since a spouse who admits to having knowledge would automatically be denied relief, the courts hearing innocent spouse cases usually must determine whether the taxpayer had "reason to know" of the substantial understatement. The standard that has been used by the courts is whether a reasonably prudent person in the taxpayer's position had reason to know or would be...

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