Relief for spouse of tax cheats.

A woman's husband invests in a complex tax shelter and claims a $3,500,000 deduction on their joint tax return. Later, after their divorce, the Internal Revenue Service informs her that she's jointly liable for past taxes, interest, and penalties because the IRS subsequently disallowed the deduction. Should she have to pay the bill even though she had limited knowledge of the tax shelter? Yes, said the U.S. Tax Court when she appealed, ruling that she jointly signed the return and is liable. No, said a U.S. circuit court of appeals, overturning the Tax Court ruling.

Generally, if a taxpayer intentionally and grossly understates income or takes inappropriate deductions, a spouse who jointly signs the return is held equally liable for any additional taxes, interest, or penalties, even if the parties are divorced at the time the IRS duns them. In fact, if the guilty party has no assets, the former spouse can be hit with the entire tax bill--even if the divorce decree commits the other spouse to be responsible for all joint tax deficiencies.

Congress passed rules allowing some relief for "innocent spouses," but the rules were tough and closely interpreted by the courts. Recent court decisions, though, have liberalized the "innocent spouse test" and given some relief to divorced taxpayers hit with tax bills because of their ex-spouses' dubious tax claims made while they were married.

For relief to be granted, several conditions must be met. The most important is that the innocent spouse must establish that he or she did not know, and had no reason to know, of the understatements. This is the area where some of the U.S. circuit courts have begun to interpret more generously. In one case, a circuit court listed four criteria that focus on determining whether a reasonably prudent person would have sufficient...