The innocent spouse rule.

• Author: McFarland, Joseph B.
• Position: Taxation

Variations on a Theme

When a couple gets married, joint returns typically are filed. The husband and wife are responsible jointly and individually for payment of correct taxes on their taxable income. One spouse may contribute little or no income to annual taxable family income, but will still be liable if the other spouse understated the amount of income tax due.

In some situations, one spouse may not be aware of incorrect tax reporting by the other spouse. Upon separation or divorce, one spouse probably will have even less knowledge of the other spouse's reporting for tax purposes. The IRS, in its role as a muscular creditor, not surprisingly insists on full payment of the taxes due. If the spouse responsible for the incorrect reporting has insufficient assets to pay the tax bill, IRS collections likely will demand the balance from the other spouse, whether the parties are still together, separated, or divorced.

The "innocent spouse" rule was developed in order to protect spouses with no knowledge of the incorrect tax reporting of the other spouse. Congress enacted the first "innocent spouse" provision in 1971, and modifications to the law were made in 1984. The rule provided limited relief, and in some circumstances created harsh results.

The IRS Restructuring and Reform Act of 1998, signed into law by President Clinton on July 22, 1998, gives further relief to innocent spouses by making the old rules more flexible. Nevertheless, the changes have created new questions that will need to be addressed by Congress.

The Old Law

Basic Requirements. Prior to the statutory changes made in 1998, the Internal Revenue Code (IRC) obliged the innocent spouse to establish: 1) that a joint return was made; 2) that an understatement of tax, which exceeded the greater of $500 or a specified percentage of the innocent spouse's adjusted gross income for the most recent taxable year prior to the date the deficiency notice was mailed, was attributable to a grossly erroneous item of the other spouse; 3) that in signing the return, the innocent spouse did not know, and had no reason to know, that there was an understatement of tax; and 4) that taking into account all the facts and circumstances, it would be inequitable to hold the innocent spouse liable for the deficiency in tax.[1] The innocent spouse carried the burden of proof.[2] A failure to prove any one element would prevent such person from qualifying as an "innocent spouse."[3]

Significant Understatement of Tax. One requirement was that the tax understatement be the greater of $500 or more than 10 percent of the innocent spouse's adjusted gross income if the spouse's income was $20,000 or less.[4] If the spouse's income was $20,000 or more, the specified percentage had to be more than 25 percent.

Grossly Erroneous Items. The old law required not only that there be a certain understatement of tax, but also that there be gross reporting errors attributable to the "guilty" spouse. Grossly erroneous items included unreported income and any deductions, credits, or property bases claimed for which there was no basis in fact or law.[5] A misunderstanding of the tax consequences of a sale did not qualify.[6] Failure to provide sufficient evidence to convince the IRS of a tax position did not necessarily rise (or sink) to the level of "grossly erroneous."[7]

In IRS Publication 971 (Innocent Spouse Relief (4/98), the following examples of "grossly erroneous" are given:

(1) The expense for which the deduction is taken was never made. (For example, your spouse deducted $10,000 of advertising expenses of Schedule C (Form 1040), but never paid for any advertising.) (2) The expense does not qualify as a deductible expense under well-settled legal principles. (For example, your spouse claimed a business fee deduction of $10,000 that was for the payment of state fines; fines are not deductible.) (3) No substantial legal argument can be made to support the deductibility of the expense. (For example, your spouse claimed $4,000 for security costs related to a home office, which were actually veterinary and food costs for your family's two dogs.)

Reason to Know. The court in Sanders v. United States, 509 F.2d 162, 167 (5th Cir. 1975), held that a spouse had "reason to know" if a reasonably prudent taxpayer under the circumstances of the spouse at the time of signing...