If a taxpayer prevails under the provisions of Innocent Spouse Relief, the taxpayer will be freed of that tax-liability shackle. Tax Attorney (NY Bar, CO CPA) Philip Falco provides you with Tax Tips based on the Ehrmann case and based on his insight and then discusses the requirements for Innocent Spouse Relief. He discusses a recent tax case drafted by the United States Tax Court, Kathryn D. Ehrmann v. Commissioner of Internal Revenue, T.C. Summary Opinion 2014-96. This is a very recent case, which is dated September 23, 2013. This case may not be relied upon as precedent, but it is still telling of the Court’s view on Innocent Spouse Relief cases.
Tax Tips for those entering or exiting marriage (Divorce) as to Innocent Spouse Relief by Tax Lawyer Philip Falco:
- Consider not paying the tax in dispute,
- Hire competent tax counsel to draft tax language in divorce decree, stipulation, or settlement agreement,
- Consider filing your tax return using a different filing status such as separately or head of household (if qualified).
- Before getting married, hire us to do a tax compliance checkup on your fiancé. If you are getting married a bit older in life, this actually makes sense since you really would not know a person’s tax history. Concealment of prior tax history is a common reason for petitions under Innocent Spouse Relief.
Innocent Spouse Relief, Equitable Relief: the catch-all
Generally, married taxpayers who file a joint Federal income tax return are jointly and severally liable for the tax reported or reportable on the return. Sec. 6013(d)(3); Butler v. Commissioner, 114 T.C. 276, 282 (2000). Section 6015, however, allows a spouse to obtain relief from joint and several liability in certain circumstances.
Section 6015(a)(1) provides that a spouse who has made a joint return may elect to seek relief from joint and several liability under subsection (b) (dealing with relief from liability for an understatement of tax with respect to a joint return). Section 6015(a)(2) provides that an eligible spouse may elect to limit that spouse’s liability for any deficiency with respect to a joint return under subsection (c) (dealing with relief from joint and several liability for taxpayers who are no longer married or who are legally separated or no longer living together). If a taxpayer does not qualify for relief under either subsection (b) or (c), the taxpayer may seek equitable relief under subsection (f).
Equitable Innocent Spouse Relief: Requirements
There are seven threshold conditions that a requesting spouse must satisfy to be eligible for relief under section 6015(f):
- the requesting spouse filed a joint Federal income tax return for the tax year or years for which relief is sought;
- the requesting spouse does not qualify for relief under section 6015(b) or (c);
- the claim for relief is timely filed;
- no assets were transferred between the spouses as part of a fraudulent scheme;
- the nonrequesting spouse did not transfer disqualified assets to the requesting spouse;
- the requesting spouse did not knowingly participate in the filing of a fraudulent joint return; and
- the liability from which relief is sought is attributable to an item of the nonrequesting spouse.
If a requesting spouse satisfies the threshold conditions of Rev. Proc. 2013-34, sec. 4.01, the Commissioner considers whether the requesting spouse is entitled to a streamlined determination of equitable relief under section 6015(f). If a requesting spouse is not entitled to a streamlined determination because the requesting spouse does not satisfy all the elements in Rev. Proc. 2013-34, sec. 4.02, the requesting spouse’s request for relief may be considered using the equitable relief factors in Rev. Proc. 2013-34, sec. 4.03.
Under Rev. Proc. 2013-34, sec. 4.03, equitable relief under section 6015(f) may be granted if, taking into account all the facts and circumstances, it would be inequitable to hold the requesting spouse responsible for all or part of the liability. In making the decision, the Commissioner weighs a number of factors, including, but not limited to:
- Marital status. Whether the requesting spouse is no longer married to the nonrequesting spouse as of the date the Service makes its determination.
- Economic hardship. Whether the requesting spouse will suffer economic hardship if relief is not granted.
- Knowledge or reason to know. In the case of an income tax liability that was properly reported but not paid, whether, as of the date the return was filed or the date the requesting spouse reasonably believed the return was filed, the requesting spouse knew or had reason to know that the nonrequesting spouse would not or could not pay the tax liability at that time or within a reasonable
period of time after the filing of the return.
- Legal obligation. Whether the requesting spouse or the nonrequesting spouse has a legal obligation to pay the outstanding Federal income tax liability.
- Significant benefit. Whether the requesting spouse significantly benefitted from the unpaid income tax liability or understatement.
- Compliance with income tax laws. Whether the requesting
spouse has made a good faith effort to comply with the income tax
laws in the taxable years following the taxable year or years to which
the request for relief relates.
- Mental or physical health. Whether the requesting spouse was in poor physical or mental health.
“Weighs” is highlighted because not ALL of the factors need be present, which is especially true in the Ehrmann case, as discussed below.
Kathryn D. Ehrmann v. Commissioner of Internal Revenue, T.C. Summary Opinion 2014-96, September 23, 2014, sheds light on “economic hardship”.
For purposes of this factor, an economic hardship exists if satisfaction of the tax liability, in whole or in part, will cause the requesting spouse to be unable to pay reasonable basic living expenses. Id. sec. 4.03(2)(b), 2013-43 I.R.B. at 401. The facts and circumstances considered in determining whether the requesting spouse will suffer economic hardship include:
- the requesting spouse’s age, employment status and history, ability to earn, and number of dependents;
- the amount reasonably necessary for food, clothing, housing, medical expenses, transportation, and current tax payments; and
- any extraordinary circumstances such as special education expenses, a medical catastrophe, or a natural disaster.
- In addition, consideration is given to the requesting spouse’s current income and expenses and the requesting spouse’s assets.
Ms. Ehrmann, the court found, would not suffer economic hardship if relief were denied based on the following facts:
- Ms. Ehrmann sought a refund of money that had already been paid. Thus, her current financial circumstances will not be adversely affected if relief is denied. TAX TIP: Consider not paying the disputed tax.
- Ms. Ehrmann earned significant income from her position as a senior managing director at CB Richard Ellis. On her Form 8857 petitioner estimated that her 2011 salary and bonus would total over $300,000. In her affidavit filed with the Hennepin County District Court, petitioner disclosed that she earned nearly $340,000 in salary and bonuses for 2011. Moreover, nothing in the record suggests that Ms. Ehrmann’s earning potential has declined since then.
- Ms. Ehrmann owned substantial assets, including the Wayzata and Hilton Head residences and a number of luxury vehicles.
- Although petitioner had no dependents, her expenses include expenses paid to support her adult children.
In the end, the Court found this factor neutral. It is pointed out and highlighted that the tax court did not find this factor as weighing against Ms. Ehrmann.
The tax court stated, citing Rev. Proc. 2013-34, sec. 4.03(2)(b), “[t]his factor weighs in favor of relief where the requesting spouse would suffer economic hardship if relief is denied and is neutral where the requesting spouse would not suffer economic hardship if relief is denied.”
Implied by the Rev. Proc. and the tax court is that economic hardship either works in favor of the petitioning taxpayer or is a neutral factor, but NOT a factor weighing against Innocent Spouse Relief.
As such, wealth of the taxpayer seeking Innocent Spouse Relief is NOT weighed against the taxpayer.
Innocent Spouse Relief is available to the rich, which is counter intuitive in my view.
For purposes of this factor, a legal obligation is an obligation arising from a divorce decree or other legally binding agreement. Rev. Proc. 2013-34, sec. 4.03(2)(d), 2013-43 I.R.B. at 402. This factor weighs in favor of relief if the nonrequesting spouse has the sole legal obligation to pay the outstanding income tax liability pursuant to a divorce decree or agreement and weighs against relief if the requesting spouse has the sole legal obligation. Id. This factor is neutral if both spouses have a legal obligation to pay pursuant to a divorce decree or agreement or if the divorce decree or agreement is silent as to any obligation to pay the outstanding income tax liability.
In a carefully drafted divorce decree, stipulation, or settlement, an ‘Innocent Spouse’ may successfully plead this factor. We provide tax counsel to spouses during the process of divorce. In Ehrmann, the decree was drafted in a way that could have been improved. I won’t shed more light on this issue at this time, but feel free to contact me. As such, the tax court found this factor neutral.