Innocent or Not: Let the Factors Decide

When a married couple elects to file jointly, they are agreeing to share and share alike: Each spouse is liable for the full tax due. If the IRS cannot collect the taxes from one spouse, it will attempt to collect 100% of the tax due from the other, not just 50%.1 This also holds true for any interest and penalties that may have accrued.

Sometimes a couple who initially elected to use the married filing jointly status later has one spouse who wishes they had not. This spouse may not have any knowledge of what was reported on the tax return or why it was wrong but finds that he or she is responsible for 100% of the tax due under Sec. 6013(d)(3). However, the unhappy spouse may find relief in the innocent spouse provisions of Sec. 6015. This article focuses on the equitable relief available under Sec. 6015(f) and discusses a recent case that provides insight into how the courts apply the factors in real life.

The Internal Revenue Service Restructuring and Reform Act of 19982 enacted Sec. 6015, which provides relief in certain circumstances from joint and several liability. Sec. 6015(b) provides relief from understatement of tax for innocent spouses, and Sec. 6015(c) limits the innocent spouse’s liability for tax when the spouses are no longer married. In the event that the taxpayer does not qualify for relief under these two subsections, Sec. 6015(f) may be helpful. Sec. 6015(f) authorizes the IRS to grant relief if, taking into account all the facts and circumstances, the IRS determines that it is inequitable to hold a requesting spouse liable for any unpaid taxes or any deficiency (or any portion of either).

Innocent Spouse Relief

These general conditions must be satisfied in order to seek relief from liability under Sec. 6015(b):3

1. a joint return has been made for a taxable year;
2. on that return there is an understatement of tax attributable to erroneous items of one individual filing the joint return;
3. the other individual filing the joint return establishes that in signing the return he or she did not know, and had no reason to know, that there was such understatement;
4. taking into account all the facts and circumstances, it is inequitable to hold the other individual liable for the deficiency in tax for such taxable year attributable to such understatement; and
5. the other individual elects (in such form as the Secretary may prescribe) the benefits of this subsection not later than the date which is 2 years after the date the Secretary has begun collection activities with respect to the individual making the election.

Note that subparagraph (E) prescribes a two-year time limit for the requesting spouse to act. It also states that collection activities must have begun.

Taxpayers who are no longer married at the time they are making the request can seek relief under Sec. 6015(c). Under this subsection, the innocent spouse’s liability will be limited to the portion of the deficiency that is allocable to that spouse under procedures spelled out in Sec. 6015(d). Conditions must be satisfied here as well:

1. at the time such election is filed, such individual is no longer married to, or is legally separated from, the individual with whom such individual filed the joint return to which the election relates; or
2. such individual was not a member of the same household as the individual with whom such joint return was filed at any time during the 12-month period ending on the date such election is filed.4

In addition, the individual and his or her spouse must not have engaged in an asset transfer as part of a fraudulent scheme.5 A fraudulent scheme includes a scheme to defraud the IRS or another third party, including, but not limited to, creditors, ex-spouses, and business partners.6

The individual can make the election after a deficiency for the year at issue is asserted but not later than two years after the date on which the IRS has begun collection activities with respect to the individual making the election.7

If the individual making the election had actual knowledge, at the time he or she signed the return, of any item giving rise to a deficiency (or portion thereof) that is allocable to his or her spouse under Sec. 6015(d), the individual will not be granted relief for that deficiency or portion of the deficiency.8 However, this exception does not apply where the individual establishes that he or she signed the return under duress.

Note: If no collection activities have taken place, the taxpayer cannot make use of Secs. 6015(b) or (c) and must look to Sec. 6015(f) for relief.

Equitable Relief

When a taxpayer does not qualify for relief under Secs. 6015(b) or 6015(c), he or she can turn to Sec. 6015(f) for equitable relief. This section can provide help only when the taxpayer cannot obtain relief under Sec. 6015(b) or 6015(c).

There are a number of threshold conditions that must be satisfied for the IRS to consider any request for equitable relief. The IRS has given guidance in two revenue procedures for those taxpayers seeking relief under Sec. 6015(f). Exhibit 1 lists the conditions required by Rev. Proc. 2000-15.9 This procedure has been superseded by Rev. Proc. 2003-6110 (Exhibit 2). The conditions under both revenue procedures are provided here for the purpose of comparison and, more importantly, because some of the litigation analyzed below took place while Rev. Proc. 2000-15 was in effect.

The major difference between the conditions in the two revenue procedures is found in item 7 of the threshold conditions of Rev. Proc. 2003-61. The requesting spouse can request relief from tax liability only when the liability arises from an item belonging to the nonrequesting spouse. However, Rev. Proc. 2003-61 has provided some exceptions, which involve community property, nominal ownership, misappropriation of funds, and duress.

Generally, relief will be granted under Sec. 6015(f) if three safe-harbor conditions are met.11 Briefly, the first condition states that the requesting spouse can no longer be married to, or is legally separated from, the nonrequesting spouse. Second, when the requesting spouse signed the return, the requesting spouse must have had no knowledge or reason to know that the tax would not be paid. The final condition is that the requesting spouse would suffer economic hardship if the IRS does not grant relief.

Even when a taxpayer does not satisfy the three safe-harbor conditions, there is still some hope. Eight factors are to be considered in determining whether it would be inequitable to hold a requesting spouse jointly and severally liable.12 The eight factors are:

• Marital status;
• Abuse;
• Significant benefit;
• Later compliance with federal tax laws;
• No knowledge or reason to know;
• Economic hardship;
• Attribution; and
• Nonrequesting spouse—legal obligation.

These factors are largely repeated in Rev. Proc. 2003-61, although, as noted, attribution has been moved up to be a threshold condition, and the requesting spouse’s physical or mental health has been added as a factor the IRS will consider.

A recent Tax Court case13 demonstrates the operation of Sec. 6015(f) and the requirements, safe harbors, and factors to be used when dealing with innocent spouse eligibility. The court applied Rev. Proc. 2000-15 in the Wilson case because this is the procedure that was in effect during the tax years at issue in the case. As previously mentioned, Rev. Proc. 2003-61 has superseded Rev. Proc. 2000-15. Had the court applied Rev. Proc. 2003-61 in the Wilson case, it is likely that the outcome would have been the same. The taxpayer would still have prevailed and would have obtained the relief she sought.

Karen Marie Wilson was married in 1983 to Lloyd Wilson. Because the family’s financial framework was simple, Karen would prepare their annual tax return. In 1997, their financial situation changed drastically when Lloyd became involved in a Ponzi scheme. Since their financial situation had become more complex, Karen no longer handled their tax returns.

In May 1999, the family’s financial picture changed once again. The Securities and Exchange Commission (SEC) issued a cease and desist order, which put an abrupt end to Lloyd’s business. The couple’s tax returns for 1997 and 1998 had omitted substantial amounts of income. A tax practitioner prepared amended returns for both years as well as an original return for 1999, resulting in a total tax liability of $540,000. The Wilsons did not pay this amount at the time they filed the returns.

As the Wilsons’ financial world crumbled, so did the marriage. Karen, who was not aware of the troubles with the SEC until 2000, could not afford to move out on her own; however, she maintained a separate bedroom, celebrated holidays separately, and did her best to avoid Lloyd.

In March 2002, Karen sought innocent spouse relief for tax years 1997, 1998, and 1999. In March 2003, Karen received a letter from the IRS denying her request. Karen filed for divorce in April 2004. In July 2004, an IRS Appeals officer asked her to contact him by August 18, 2004, for a telephone hearing. Karen never contacted the officer, and in September she received a notice of determination denying her request for relief. Karen moved out in early 2005; she petitioned the Tax Court and her case was tried in September 2005.

Karen Wilson’s only hope for relief was Sec. 6015(f) because the IRS never assessed a deficiency against her, which is a requirement for relief under Secs. 6015(b) and 6015(c). Karen had asked for relief on her own initiative and not in response to any action taken by the IRS to collect a tax debt.

To complicate matters further, when Karen petitioned the court, the Tax Court lacked jurisdiction over stand-alone nondeficiency cases, which is what Karen Wilson’s case was. In late 2006, Congress enacted the Tax Relief and Health Care Act of 2006,14 giving the Tax Court jurisdiction over stand-alone nondeficiency cases. This added Sec. 6015(e) to the Code, which gave the court jurisdiction over the Wilson case.

In Karen Wilson’s case, the IRS conceded that she met all seven requirements for relief under Sec. 6015(f). Unfortunately, Karen failed the first test of the three safe-harbor conditions under Rev. Proc. 2001-15, which states that at the time the request is made, the requesting spouse is no longer married to, or is legally separated from, the nonrequesting spouse or was not a member of the same household as the nonrequesting spouse at any time during the 12-month period ending on the date relief was requested. Karen told the court that she had moved into a different bedroom, celebrated holidays separately, and had done her best to avoid Lloyd since 2001. As such, she argued that she was no longer a member of the same household. However, in her innocent spouse petition she had indicated that she was married and living with Lloyd at the time she filed the request for relief, and she did not have a separate household.

Because she failed the safe-harbor conditions, she was left with the eight-factor balancing test as the last hope. The court applied these eight factors to the facts of her case.

Marital status: The requesting taxpayer must be legally separated or divorced in order to qualify. Initially, this factor seemed to weigh against Karen because she was not divorced when she initially applied for relief. However, the court found that her circumstances at the time of the new trial had changed. Her marriage was formally dissolved in April 2007. Accordingly, the court determined that the marital status factor now weighed in favor of granting relief.

Abuse: The court determined that there was no abuse. As such, it considered this factor to be neutral.

Significant benefit: The question here was whether Karen received a significant benefit from the unpaid tax liability or items giving rise to the deficiency. Both the IRS and the court found in Karen’s favor on this issue. Lloyd had stopped providing normal support and Karen was struggling financially, so the significant benefit factor weighed in favor of granting relief.

Later compliance with federal tax laws: Karen owed small amounts in connection with her 2001 and 2002 returns. She later paid these balances in full. She also owed approximately $2,000 for her 2004 tax return but said she intended to resolve the matter and the court believed her. However, she failed to provide evidence of this intent, so the court found that it weighed slightly against granting relief.

No knowledge or reason to know: At the time Karen signed the returns, did she know or have reason to know that the tax liability would not be paid? The court found that Karen believed Lloyd would pay the 1997 and 1998 tax liabilities. At the time of the signing, Lloyd had considerable earnings in addition to the equity in two houses they had purchased, and he had always paid tax liabilities in the past.

With respect to the 1999 return, Karen’s position was not as clear. The Wilsons signed the 1999 return on December 30, 1999. At that time, they filed amended 1997 and 1998 returns showing additional tax due. The 1999 return alone reflected a $98,000 tax liability, with $20,000 in estimated tax payments and a balance due of $78,000. At this time Lloyd was still working, but the SEC had issued the cease and desist order. Karen did not know about the order until 2000 at the earliest. The court found that considering the family’s assets, Karen could have been in a position to believe that there would be sufficient funds to pay the remaining $78,000. When the court took these facts into consideration, together with her lack of business sophistication and limited education, it believed she lacked any reason to know that Lloyd would fail to pay the taxes owed. After all, in spite of the hundreds of thousands of dollars in additional taxes owed, the amended returns showed close to a million dollars in extra income that Lloyd was not spending at home. Therefore, the court found that this factor favored granting relief.

Economic hardship: The records indicated that Karen’s monthly income exceeded her expenses by $114. It was determined that with $540,000 in outstanding tax liabilities, an uncertain financial future, and a lifestyle that was anything but luxurious, the economic hardship factor weighed in favor of granting relief.

Attribution: The question here is whether or not the tax liability was attributable to Lloyd. In the opinion of the IRS, Karen was responsible for a portion of the liabilities. The court did not agree and held that this factor favored granting relief.

Nonrequesting spouse—legal obligation: This last factor involves whether the divorce decree addresses the issue of tax liability, which was not applicable in this case.

With five of eight factors favoring relief, two neutral factors, and only one slightly against, the court granted Karen Wilson innocent spouse relief.

How Does a Spouse Obtain Innocent Spouse Relief?

A taxpayer seeking innocent spouse relief needs to obtain and file Form 8857, Request for Innocent Spouse Relief, with the IRS. This form is several pages long and asks numerous questions. On page 1 of the form, the IRS asks the requesting taxpayer to provide information not only about himself or herself but also about the spouse.

Observation: It should be noted that the IRS will notify the requesting taxpayer’s spouse of the request. In some cases, this can be perilous, and Form 8857 warns that there are no exceptions to this notification, even in cases of spousal abuse or domestic violence.

The form also asks about the educational level of the requesting spouse. This point might come into play when determining whether the requesting spouse had “no knowledge or reason to know” that the tax liability would not be paid. It should not be presumed that a requesting spouse who is highly educated will automatically be denied innocent spouse relief. For example, one case15 involved a woman who held a Ph.D., but she did not have any education or work experience in tax, financial, or accounting matters. Her husband handled all the family’s financial affairs. After reviewing the facts and circumstances, the court granted innocent spouse relief.

Statute of Limitation

There is another important factor regarding the procedure to obtain innocent spouse relief: the two-year limitation in connection with filing the request. The Code imposes the two-year limit for claims under Secs. 6015(b) and (c). The IRS has issued regulations that also impose a two-year limitation period on claims for relief under Sec. 6015(f).16 The Tax Court has held in three cases that this regulation is invalid.17 However, the Seventh Circuit overruled the Tax Court in one of the cases, and the Third Circuit overruled it in another.

In Lantz,18 Cathy Marie Lantz sought innocent spouse relief. Her spouse, Richard M. Chentnik, was a dentist to whom she had been married to for six years. Chentnik was arrested for Medicare fraud in 2000, and the IRS assessed the couple for more than $900,000 in additional taxes, interest, and penalties. Chentnik told his wife that he would take care of all the paperwork to obtain innocent spouse relief for her. Unfortunately, he died before filing on her behalf. Three years later, Lantz discovered that her husband had not taken care of the matter and filed a Form 8857. The IRS rejected her claim as untimely because she had filed it after the expiration of the two-year limitation period. The IRS conceded that were it not for the deadline, Lantz would be eligible for relief. Lantz appealed the IRS’s determination in the Tax Court. In particular, she challenged the validity of Regs. Sec. 1.6105-5(b)(1), which states:

To elect the application of §1.6015-2 or 1.6015-3, or to request equitable relief under §1.6015-4, a requesting spouse must file Form 8857 or other similar statement with the Internal Revenue Service no later than two years from the date of the first collection activity against the requesting spouse after July 22, 1998, with respect to the joint tax liability.

Because the Code specifically contains a two-year limitation in Secs. 6015(b) and (c) but does not repeat the limitation in Sec. 6015(f), the issue was one of statutory intent. The Tax Court believed that since Congress had specifically omitted the two-year limitation from Sec. 6015(f), coupled with the fact that Sec. 6015(f) provided relief that could not be obtained under Secs. 6015(b) or 6015(c), it was Congress’s intent that the two-year limitation did not apply in connection with Sec. 6015(f). Accordingly, the Tax Court held that the regulations were invalid.

On appeal, the Seventh Circuit, agreeing with the IRS’s interpretation in this matter, reversed the Tax Court.19 The court noted that while the two-year limitation was not specifically stated in Sec. 6015(f), that subsection does call for relief to be granted “[u]nder procedures prescribed by the Secretary.” Thus, according to the court, Congress granted the IRS authority to devise the appropriate substantive and relevant procedures to be followed, including deadlines. The court did agree that its denial of Lantz’s claim for equitable relief was a harsh result. However, it found that she would have avenues of relief because, due to her meager resources, the IRS would likely classify the debt as “currently not collectible.”

In the Mannella case,20 the Third Circuit, analyzing the regulation under the Chevron21 standard, also held that the two-year statute of limitation was valid. The court found Sec. 6015(f) to be ambiguous, found nothing in the legislative history that clearly demonstrated Congress’s intent, and held the two-year limit to be a proper exercise of the IRS’s regulatory authority.

Conclusion

After considering all the requirements, safe harbors, and factors discussed herein, practitioners should remind clients of the following important points. First, taxpayers should be careful when selecting a filing status. The married filing jointly filing status can cause problems. If taxpayers are no longer happily married, or are no longer married at all, this will not prevent the IRS from seeking tax payments from one spouse for the liability of the other spouse. Taxpayers who find themselves in such a situation should act quickly when seeking innocent spouse relief to avoid problems dealing with the statute of limitation.

Practitioners should be mindful of what the taxpayer should and should not have known about the household’s financial situation. A requesting spouse who is taking elaborate trips, buying expensive cars, and living a luxurious lifestyle will have trouble claiming to have no knowledge of the household’s financial position. If the requesting spouse is receiving significant benefits from the unpaid liability, this spouse is less likely to be successful in requesting innocent spouse relief. In addition, as both the Tax Court and the Ninth Circuit22 have held, the IRS can deny innocent spouse relief to a spouse because she took a substantial role in managing the family’s investments and therefore knew or had reason to know of the return understatements that gave rise to the liability.

Practitioners should try to ensure that clients can demonstrate later compliance with federal tax laws and how denial of an innocent spouse claim will cause them economic hardship. Finally, advisers should remember that if the client cannot find relief under the conditions of Secs. 6015(b) or (c), equitable relief may be available under Sec. 6015(f).

Footnotes

¹ Sec. 6013(d)(3).

² Internal Revenue Service Restructuring and Reform Act of 1998, P.L. 105-206.

³ Sec. 6015(b)(1).

⁴ Sec. 6015(c)(3)(A)(i).

⁵ Sec. 6015(c)(3)(A)(ii).

⁶ Regs. Sec. 1.66-4(f).

⁷ Sec. 6015(c)(3)(B).

⁸ Sec. 6015(c)(3)(C).

⁹ Rev. Proc. 2000-15, 2000-1 C.B. 447.

¹⁰ Rev. Proc. 2003-61, 2003-2 C.B. 296.

¹¹ Rev. Proc. 2003-61.

¹² Rev. Proc. 2000-15.

¹³ Wilson, T.C. Memo. 2010-134.

¹⁴ Tax Relief and Health Care Act of 2006, P.L. 109-432.

¹⁵ Korchak, T.C. Memo. 2006-185.

¹⁶ Regs. Sec. 1.6015-5(b)(1).

¹⁷ Lantz, 132 T.C. 131 (2009), rev’d, 607 F.3d 479 (7th Cir. 2010); Mannella, 132 T.C. 196 (2009), rev’d, 631 F.3d 115 (3d Cir. 2011); and Hall, 135 T.C. No. 19 (2010).

¹⁸ Lantz, 132 T.C. 131 (2009).

¹⁹ Lantz, 607 F.3d 479 (7th Cir. 2010).

²⁰ Mannella, 631 F.3d 115 (3d Cir. 2011).

²¹ Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).

²² Capehart, 204 Fed. Appx. 618 (9th Cir. 2006), aff’g T.C. Memo. 2004-268.

EditorNotes

Mary Recor is an assistant professor at the City University of New York–College of Staten Island in New York, NY. For more information about this article, contact Prof. Recor at mary.recor@csi.cuny.edu.