Treatment of community income for spouses living apart.

• Author: Karnes, Allan
• Position: Part 2

EXECUTIVE SUMMARY

* Under Sec. 66(c), traditional relief can be granted for deficiencies due to omitted income items, while equitable relief can apply to any deficiency or unpaid tax.

* For traditional relief, the requesting spouse must establish that he or she did not know, and had no reason to know, of the income item.

* Rev. Proc. 2003-61 specifies the five threshold requirements for Sec. 66(c) equitable relief and a nonexclusive list of factors that the IRS should consider if the threshold requirements are met.

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Sec. 66 provides reporting and liability relief for married, but separated, taxpayers living in community property states. Part II of this two-part article explains and illustrates the requirements for traditional and equitable relief under Sec. 66(c).

This two-part article offers guidance on Sec. 66 relief to practitioners with married clients who are separated and reside in community property states. Part I, in the March 2006 issue, discussed relief from the community property laws under Sec. 66(a), and how the IRS has the power to deny the benefits of the community property laws under Sec. 66(b). Part II, below, explains and illustrates Rev. Proc. 2003-61 (34) and the Sec. 66(c) regulations, which provide traditional or equitable relief to spouses in certain cases.

Traditional and Equitable Relief

If a spouse seeking relief from the effects of the community property laws does not qualify under Sec. 66(a), relief may still be possible under Sec. 66(c) and Regs. Sec. 1.66-4. There are two types of Sec. 66(c) relief--traditional and equitable. Under Regs. Sec. 1.66-4(c), traditional relief is available only for deficiencies arising out of omitted items of income. Equitable relief, however, can be granted for any deficiency or unpaid tax (or any portion of either), as long as it was not paid as of July 22, 1998 or arose thereafter.

Traditional Relief

Four conditions must be met to qualify for traditional relief." (35)

1. The spouse did not file a joint return;

2. The spouse did not include an item of community income in gross income that would be treated as the income of the other spouse under Sec. 879(a);

3. The spouse establishes that he or she did not know, and had no reason to know, of the item of community income; and

4. After examining all of the facts and circumstances, it would be inequitable to include the item of community income in the spouse's gross income.

The first two conditions are straightforward. Proposed regulations required the requesting spouse to have filed a separate return for the year in question. (36) The final regulations, however, require only that he or she did not file a joint return. (37) Under the second condition, if the requesting spouse filed a return, it could not include an item of community income that would be attributed to the nonrequesting spouse under Sec. 879(a). (38)

The third and fourth conditions are much more subjective. Under the third condition in Regs. Sec. 1.66-4(a)(1)(iii), the requesting spouse must establish that he or she did not know, and had no reason to know, of the item of community income. This regulation is straightforward in denying relief if the requesting spouse had actual knowledge of the item of community income. However, the answer is less clear when the issue is whether the requesting spouse had a "reason to know" under Regs. Sec. 1.66-4(a)(2)(i). This is determined by a "reasonable person" standard--would a reasonable person in similar circumstances have known of the item of community income. All relevant facts and circumstances must be considered, including:

* The nature of the item of community income;

* The amount of the item in relation to other income items;

* The couple's financial situation;

* The requesting spouse's education and business experience; and

* Whether the item was included on the couple's prior returns.

Nature and amount: If the requesting spouse knows the nature of the item but not the specific amount, he or she has the requisite knowledge or reason to know. (39) The IRS maintains that this is consistent with the case law--if a spouse knows of the community income-producing activity but not the amount, a reasonably prudent person would determine the amount of community income earned during the year in question. (40) However, if the requesting spouse does not have actual knowledge of the income-producing activity, reason to know should not be attributed to the requesting spouse unless he or she benefited from the item of community income. (41)

The IRS's insistence on ignoring the requesting spouse's ability to determine the amount of community income may allow an unscrupulous nonrequesting spouse to avoid being taxed on all the community income he or she earned. As long as the requesting spouse knows the source of the community income (e.g., employment, business or investment), knowledge sufficient to defeat Sec. 66(c) traditional relief is attributed to the requesting spouse, even if the nonrequesting spouse refuses to inform the requesting spouse about the amount of the community income and refuses to share the income. The result presumably is the same even if the nonrequesting spouse is simply behaving badly. For example, if the nonrequesting spouse refuses to speak or exchange information with the requesting spouse due to anger, knowledge will be attributed to the requesting spouse as long as he Or she has knowledge of the income-producing activity. And, in most marriages, it is likely that each spouse knows of the other's business activities. Such situations could have been avoided if the regulation had put more emphasis on the requesting spouse's ability to determine the amount of community income. Of course, if the nonrequesting spouse has refused to notify the requesting spouse of the amount, he or she may be subject to Sec. 66(b) action if he or she also acted as if solely entitled to the income. (42)

Facts and circumstances: The fourth condition for traditional relief requires that it be inequitable to include the item of community income in the requesting spouse's gross income after taking into account all facts and circumstances. (43) Relevant factors include desertion, divorce or separation. The most difficult issue for many requesting spouses is whether they benefited (directly or indirectly), from the omitted item of community income. "Benefit" includes normal support, but not de minimis amounts. (44) The final regulations are more stringent than the proposed regulations in this...