Innocent spouse prop. regs. offer relief.

• Author: Foran, Nancy J.

EXECUTIVE SUMMARY

* Sec. 6015 offers three categories of JSL relief: (1) innocent spouse relief; (2) deficiency allocation by taxpayers no longer married, legally separated or not living together; and (3) equitable relief.

* If an RS had actual knowledge of an erroneous item when the joint return was signed, he remains liable for the deficiency attributable to that item.

* The number of innocent spouse cases received by the IRS has increased from 3,000 to 5,000 new cases per month.

The innocent spouse relief provisions included in the Internal Revenue Service Restructuring and Reform Act of 1998 have now been explained in proposed regulations. The rules address innocent spouse relief, the deficiency-allocation election and equitable relief. This article's many examples provide guidance through the regulatory maze.

Earlier this year, Treasury issued proposed regulations(1) on the innocent spouse rules enacted by the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98). The regulations apply to liabilities arising after July 22, 1998, and to those arising before that date but unpaid before July 23, 1998. The rules will be effective for relief elections and requests filed on or after the date the final regulations are published.

Background

Sec. 6013(d)(3) imposes joint and several liability (JSL) on married couples filing jointly. JSL allows the government to collect a tax liability (including penalties and interest) from either spouse. Prior to the enactment of the IRSRRA '98, Sec. 6013(e) provided JSL relief to an innocent spouse only for large tax understatements and grossly erroneous items. In 1998, Congress replaced Sec. 6013(e) with Sec. 6015 in the belief that the prior law did not adequately remedy the JSL issue.(2) Sec. 6015 offers three categories of JSL relief: (1) innocent spouse relief; (2) deficiency allocation by taxpayers no longer married, legally separated or not living together; and (3) equitable relief.

JSL Relief

To obtain JSL relief, a "requesting spouse" (RS) may submit a single claim electing innocent spouse relief and/or a deficiency allocation and requesting equitable relief. Form 8857, Request for Innocent Spouse Relief (And Separation of Liability and Equitable Relief), can be used to submit the "election" or "request" (Terms in quotes are defined in Exhibit 1 on p. 686.)

Exhibit 1: Definitions Prop. Regs. Sec. Term Definition 1.6015 Assessment to which The entire assessment -7(c)(3)(iii) the election relates deficiency to which the election relates, even if the election is made for only part of the deficiency. Child Does not include a -3(d)(4)(iii) stepson or stepdaughter, unless legally adopted. Disqualified asset Property or right to -3(c)(3)(ii) property transferred from the NS to the RS, if the principal purpose of the transfer is to avoid tax or the payment of tax. Divorced The RS has a divorced -3(b)(1) degree recognized in his jurisdiction of residence. Election or request The first timely claim -1(g)(5) for relief for the tax year for which relief is sought. The second election for a deficiency allocation if the requirements for an allocation were not met when the first election was considered, but were met when the second election was made. Erroneous item Item resulting in a tax -1(g)(4) understatement or deficiency, to the extent it is omitted from or improperly reported or charac- terized on an individual return. Inequitable All facts and circums- -2(d) tances are considered, particularly whether the RS directly or indi- rectly significantly benefited. Item Gross income, deduc- -1(g)(3) tions, credits, basis, etc., required to be separately listed on an individual return or a required attachment. Investment amounts received from the same source are aggregated and treated as one item. Knowledge or 1. Actually knew of the -2(c) reason to know item or 2. A reasonable person in similar circumstances would have known of the item. Legally separated The separation is -3(b)(2) recognized in the jurisdiction of the RS's residence. Levy A Sec. 6331 administra- -7(c)(3)(i) tive levy or seizure. Nonrequesting spouse (NS) Individual who filed a -1(g)(2) joint return with the RS. Not members of the same Live in separate -3(b)(3) household dwellings and not tempo- rarily absent from each other's household. Proceedings in court Suits filed by the U.S. -7(c)(3)(ii) for collection of Federal tax, but not the filing of pleadings and claims and other participation by the IRS or the U.S. in suits not filed by the U.S., including Tax Court cases, refund suits and bankruptcy cases. Property of the RS Property in which the RS -5(b)(2)(i) has an ownership interest, including property owned jointly with the RS, but not property that the RS owns only because of community property laws. Requesting spouse (RS) Individual who filed a -1(g)(1) joint return and elects or requests relief. Separate treatment item Allocable only to one -3(d)(4)(ii) spouse and results from the disallowance of a credit, tax or addition to tax (other than the Sec. 1 regular income tax or Sec. 55 alternate minimum tax (AMT)) required to be included with a joint return. Understatement Tax required to be shown -2(b) on the return, reduced by the excess of that tax over any Sec. 6211(b)(2) rebates. According to Prop. Regs. Sec. 1.6015-1 (a)(2), innocent spouse relief and a deficiency allocation must be affirmatively elected. If an RS makes an election, the IRS may determine that an alternative election may be more appropriate. If both elections are inappropriate, the Service can decide whether equitable relief should be granted. However, if only equitable relief is requested and cannot be granted, the IRS cannot consider either of the elective provisions.

Income, credit and deduction items are allocated to spouses without regard to community property laws. An "erroneous item" is attributed to the spouse whose activities produced the item.

Example 1: A and B filed joint returns and lived in a community property state that attributes one-half of all income earned and property acquired during marriage to each spouse. They later divorced. The IRS assessed a deficiency attributed to $75,000 of A's unreported income and $25,000 of B's disallowed deductions. B elects to allocate the deficiency. Although the state provides that one-half of the unreported income is attributable to B, for purposes of JSL relief, the $75,000 of unreported income is attributable to A; the $25,000 of disallowed deductions are attributable to B.

Knowledge of Erroneous Items

Of the three JSL relief categories, only innocent spouse relief and the deficiency allocation explicitly contain a knowledge requirement. However, that requirement differs as to the level of knowledge and which party bears the burden of proof. Although neither the Code nor the regulations specify a knowledge requirement for the equitable-relief category, Rev. Proc. 2000-15(3) includes a knowledge requirement in its list of circumstances under which equitable relief will ordinarily be granted and factors to consider in determining whether it would be inequitable to hold an RS liable.

To obtain innocent spouse relief, an RS must demonstrate that he had no (1) reason to know and (2) actual knowledge of the "item" that produced the understatement when the return was signed. Partial relief is allowed if a spouse had no reason to know and no actual knowledge of a portion of an erroneous item, but the RS bears the burden of proof.

In contrast, a deficiency-allocation election is valid unless the IRS can demonstrate that the RS had actual knowledge (at the time the return was signed) of an erroneous item allocable to the "nonrequesting spouse" (NS). Thus, the knowledge requirement does not include a reason to know; the Service bears the burden of proof.

Prop. Regs. Sec. 1.6015-1(g)(3) defines an "item" as that which is required to be separately stated on an individual return or a required attachment. However, investment amounts received from the same source are aggregated and treated as one item.

The equitable-relief knowledge requirement, as described in Rev. Proc. 2000-15, differs from the other two relief categories. Equitable relief will ordinarily be granted if, among other things, at the time the return was signed, the RS had no reason to know and no knowledge that the tax would not be paid. In addition, an RS must establish it was reasonable to believe that the other spouse would pay the tax. Thus, the reason-to-know and knowledge components are similar to that in the innocent spouse relief category. However, the knowledge relates to the payment of the tax, not the item that resulted in the understatement.

An RS who would otherwise qualify for equitable relief, except for the fact that he had partial knowledge, may be granted partial relief. If an RS does not meet the conditions for equitable relief, relief nevertheless may be granted if, taking into account all the facts and circumstances, it would be inequitable to hold the RS liable for all or part of the unpaid liability or deficiency. One factor is whether the RS had reason to know or knew (1) that the reported liability would not be paid or (2) of the item that produced the deficiency. In this case, the definition of knowledge as to an item that results in a deficiency is the same as in the innocent spouse relief category.

Reason to Know

The "knowledge or reason to know" requirement is met if an RS either actually knew of the item or if a reasonable person in similar circumstances would have known of the item. Because actual knowledge applies to all relief categories, it is discussed in detail below.

According to Prop. Regs. Sec. 1.6015-2(c), reason to know is determined by considering all the facts and circumstances, such as the (1) nature of the item; (2) amount of the item relative to other items; (3) couple's financial situation; (4) RS's educational background, business experience and...