The Continuing Evolution of the “New” Innocent Spouse Rules as Implemented and Interpreted by the Internal Revenue Service and the Courts (PART I)

By Frances D. Sheehy

and

Anthony J. Scaletta*

*The authors would like to thank Bruce Thomas, Jack Holstein, and Lynn M. Morrison from the Internal Revenue Service for their assistance in providing statistical data and information for this article.

I.                    Introduction

On July 22, 1998, new legislation governing “innocent spouse” relief from joint tax liability became effective. ^[1]   Congress enacted this legislation to make it easier to obtain relief under the innocent spouse provisions of the Internal Revenue Code (IRC). ^[2]   Part I of this article will discuss the old innocent spouse rules, the new innocent spouse rules under IRC Sections 6015(b) and (c), and the courts’ interpretation of those provisions.  Part II will discuss section 6015(f) of new law, the proposed regulations pending approval by the Department of Treasury, the Internal Revenue Service (IRS) procedures, what to expect after submission of an innocent spouse claim, and whether the flexibility in application of the innocent spouse criteria which Congress envisioned has been attained.

II.         Former Innocent Spouse Rules

Generally, the filing of a joint tax return subjects each spouse to joint and several liability for payment of the tax on the return and for any deficiency determined subsequent to the filing of the return.  Prior to 1998, to qualify for relief from joint liability, the spouse claiming to be “innocent” had to prove: 1) that the liability at issue was the result of a joint return; 2) that the return had a substantial understatement of tax, which exceeded certain limits in amount and percentage of adjusted gross income, and that the understatement was due to grossly erroneous items of the “non-innocent” spouse; 3) that in signing the return, the innocent spouse did not know, and had no reason to know, of the substantial understatement of tax; and 4) that, under the facts and circumstances, it would be inequitable to hold the innocent spouse liable for the tax deficiency. ^[3]    The innocent spouse had the burden of proving each and every element and was precluded from qualifying as an innocent spouse if he or she failed to prove them all. ^[4]  

The IRS, however, was reluctant to grant innocent spouse relief, sometimes resulting in harsh consequences. ^[5]    Some Circuit Courts of Appeal, on the other hand, were less rigid in their interpretation of the innocent spouse rules under the former law and ruled against the IRS, granting the taxpayer innocent spouse relief. ^[6]    Proving actual ignorance was not enough under prior law.  Judicial interpretation of the “not know, and had no reason to know” criteria  imposed the reasonably prudent taxpayer standard to determine if the innocent spouse had “reason to know”of the understatement. ^[7]   In determining this knowledge prong, the courts looked at all the facts and circumstances, including education, involvement in the family’s finances, deceit of the non-innocent spouse, and lavish expenditures or other clues which might alert the innocent spouse to the validity of the return. ^[8]    Nonetheless, meeting this burden of proof, especially years after the filing of the return (as in the case of tax shelter assessments made decades after the returns were filed), was difficult, if not impossible, for most innocent spouses seeking relief. 

III.        The IRS Restructuring and Reform Act of 1998

The Congressional reports expressed concern that the IRS’ handling of innocent spouses under the prior law was unreasonable. ^[9]   The new law was intended to expand application of innocent spouse relief and alleviate some of the technical barriers to granting relief.  The new legislation, in some respects, mirrors the more favorable Circuit Court decisions in expanding the availability of innocent spouse relief.  The new act replaces IRC Section 6013(e) with Section 6015, and applies to any liability for tax arising after July 22, 1998, and to any unpaid liability arising on or before that date.  Taxpayers must file the election for relief prior to July 22, 2000, or within two years after the IRS begins collection activities. ^[10]

A.                 IRC Section 6015(b)

(1)       The Expanded Traditional Innocent Spouse - 6015(b)(1)

The primary changes which IRC Section 6015(b) imposes on the prior law are elimination of the requirement that the understatement be “substantial,” and the requirement of “grossly” erroneous items. The $500 threshold and the threshold with respect to the innocent spouse’s adjusted gross income are eliminated.  The knowledge requirement and the determination that it must be inequitable to hold the innocent spouse liable remain. This change does not eliminate any of the subjective tests which precluded relief under the old law, as interpreted by the IRS and criticized by Congress as being sometimes unreasonable.  Under the new law, an innocent spouse requesting relief under section 6015(b) must establish that:1) the joint return contains an understatement of tax due to the erroneous items of the non-innocent spouse; 2) at the time the return was signed, the innocent spouse did not know, and had no reason to know, that the return contained an understatement of tax; and 3) taking into account all the facts and circumstances, it is not inequitable to hold the innocent spouse liable for the understatement. ^[11]

(2)       The Partially Innocent Spouse - 6015(b)(2)

The apportionment provisions of IRC Section 6015(b)(2) afford semi-innocent spouse relief by apportioning the liability, much like the Ninth Circuit approach in Wiksell v. Commissioner. ^[12]   Under this provision, an innocent spouse is responsible only for the tax, interest and penalties relating to the portion of the understatement of which the spouse has knowledge, or reason to know. ^[13]   As under prior law, the innocent spouse has the burden of proving lack of knowledge and reason to know of the specific items giving rise to the understatement of tax.

(3)       How the Courts are Interpreting IRC Section 6015(b)

Because the basic requirements to obtain innocent spouse relief under section 6015(b) are virtually unchanged from those under former section 6013(e), the Tax Court is relying on cases decided under former section 6013(e) for guidance in deciding claims for relief under section 6015(b). ^[14]   As under prior law, the majority of reported decisions under section 6015(b) involve whether the innocent spouse knew, or had reason to know, of the understatement of tax, and whether it would be inequitable to hold that spouse liable for such understatement.

In cases decided under former law, when an understatement of tax was attributable to income omitted from the return, the innocent spouse was denied relief if he or she had knowledge of the underlying transaction which gave rise to the income. ^[15]   The Tax Court will continue to apply the same standard for claims for relief under section 6015(b). ^[16] In order to constitute actual knowledge, however, the level of knowledge must be sufficient to permit the taxpayer to inquire into the proper tax treatment of the transaction. ^[17]   For example, in Braden v. Commissioner, the Tax Court rejected the IRS’ argument that the taxpayer had actual knowledge of the understatement of tax because he knew that his wife received distributions from his father-in-law’s estate. The taxpayer knew only that his wife was entitled to receive, and did receive, an inheritance.  There was no evidence in the record that the taxpayer knew the distributions were from the individual retirement accounts or that he had any reason to conclude the distributions were taxable. ^[18]   The Tax Court granted the taxpayer relief under section 6015(b).

The Tax Court will also continue to apply the “reasonably prudent taxpayer”standard to determine if the taxpayer has met the reason to know criteria. ^[19]    The subjective factors applied by the Tax Court to determine whether an innocent spouse has reason to know of an understatement, remain the same: 1)   the spouse’s level of education; 2)   the spouse’s involvement in the family’s business or financial affairs; 3)   the presence of lavish or unusual expenditures when compared to the family’s past levels of income, standard of living, or spending patterns; and 4)   the non-innocent spouse’s evasiveness and deceit concerning the family’s finances. ^[20]

In Kling v. Commissioner, the Tax Court held that the taxpayer did not have reason to know that the net income from her husband’s sports memorabilia activities exceeded the income he reported on the return. ^[21]   The Tax Court found that the taxpayer was aware that her husband bought, sold and traded sports memorabilia, but, after applying the aforementioned factors, found that the taxpayer had no reason to know that her husband did not report all of the net income from such activities, and granted her innocent spouse relief. ^[22]

Even if the innocent spouse does not have knowledge of the understatement of tax, and can avoid the inference that he or she should have known of the understatement, the innocent spouse will still have to demonstrate that it is inequitable to be held liable for the deficiency.  Although the statute requires consideration of all the facts and circumstances, historically the most important factor in the analysis is whether the innocent spouse “significantly benefitted” from the understatement. ^[23]    Under this criteria, the Tax Court examines evidence of the spouse’s lifestyle, expenditures and other financial matters. ^[24]   If the innocent spouse significantly benefitted from the understatement of tax, relief is usually denied ^[25] .

Although section 6015(b) expands traditional innocent spouse relief to include all understatements of tax attributable to erroneous items of the non-innocent spouse, the same issues will continue to be contested as under former section 6013(e).  Married taxpayers living with their spouses who file joint returns will still be required to negate the inference that they had reason to know that the return contained an understatement.  Further, taxpayers will still be required to establish that they did not significantly benefit from the understatement. Thus, in instances where the couple enjoys a comfortable lifestyle, it will be virtually impossible to meet the “inequitable” criteria of section 6015(b). ^[26]

B.        Election to Allocate Deficiency - 6015(c)

One of the most dramatic changes in the law is found in IRC Section 6015(c), which establishes elective rules for individuals who are divorced or separated to allocate the tax liability as if the taxpayers had filed a separate return, with any deficiency being limited to income that is attributable to the innocent spouse. ^[27]   The innocent taxpayer has the burden of proof with respect to the allocation of deficiency.  Such an allocation is based on the proportion of erroneous items attributable to each spouse, and is not a recomputation of the tax as if the return were filed married, filing separately.  Thus, erroneous income is allocated to the spouse who earned it, erroneous business deductions are likewise allocated, and personal deductions are allocated equally, unless a different allocation is indicated by the evidence. ^[28]  

To justify disallowance under this provision, the IRS has the burden of proof to show that the innocent taxpayer had actual knowledge of an item creating the understatement. ^[29]   Thus, there is a presumption that the innocent spouse did not have knowledge when applying section 6015(c).  Furthermore, if the innocent spouse shows that the return was signed under duress, even actual knowledge does not prevent relief. Relief may be reduced by the value of any disqualified assets transferred to the innocent spouse by the other spouse. ^[30]   Under the allocation provision of 6015(c), there is no inequity requirement.

As in most innocent spouse cases, the majority of reported decisions under section 6015(c) involve the issue of “knowledge.”  The Tax Court, in Cheshire v. Commissioner, set forth its knowledge standard for purposes of section 6015(c) ^[31] .  In Cheshire, the taxpayer’s husband, as a result of taking early retirement, received lump-sum retirement distributions, a portion of which was rolled over into a qualified account, and the remainder was deposited into an account held jointly by the taxpayer and her spouse. ^[32]   A portion of the retirement funds was used to pay off the mortgage on the family’s home.  Prior to signing the joint income tax return, prepared by the taxpayer’s husband, the taxpayer questioned her husband about the tax ramifications of the retirement distributions.  The taxpayer’s husband falsely told the taxpayer that he had consulted a certified public accountant, and had been advised that the portion of retirement distributions used to pay off the mortgage reduced the taxable amount of the distribution. ^[33]  

The taxpayer and her husband legally separated, and eventually divorced.  The Service determined that the taxable amount of the retirement distributions were understated. ^[34]   The taxpayer sought relief from the liability under section 6015, including deficiency allocation relief under section 6015(c).  At trial, the taxpayer argued she did not have actual knowledge of the item giving rise to the deficiency for purposes of section 6015(c), because she did not know the portion of the distribution used to satisfy the mortgage was taxable.  She admitted knowing about the receipt of the retirement distributions, the source of the retirement distributions, and the amount of the retirement distributions.  She did not, however, sign the return believing that the item on the return was incorrectly reported. ^[35]   The IRS  argued that ignorance of the tax law is no excuse, and that if the taxpayer knew of the event or transaction giving rise to the deficiency, she should be denied relief. ^[36]

The Tax Court found that the taxpayer believed her former husband’s explanation regarding the tax ramifications of the retirement distributions, and had no reason to inquire further, and that the taxpayer signed the return thinking it was a correct return. ^[37]   Nonetheless, the Tax Court held that the taxpayer had actual knowledge of the item giving rise to the deficiency, because a misapprehension as to the taxable amount of the retirement distribution is insufficient to meet the lack of actual knowledge requirement under section 6015(c). ^[38]

The knowledge standard the Tax Court adopted for purposes of section 6015(c)(3)(C) was that of “an actual and clear awareness (as opposed to reason to know) of the existence of an item which gives rise to the deficiency (or portion thereof).  In the case of omitted income (such as the situation involved herein), the electing spouse must have an actual and clear awareness of the omitted income.  Section 6015(c)(3)(C) does not require actual knowledge on the part of the electing spouse as to whether the entry on the return is or is not correct.” ^[39]

In Mitchell v. Commissioner, ^[40] the Tax Court again held that for purposes of section 6015(c), knowledge of the underlying transaction, such as the receipt of income and the amount thereof,  constitutes actual knowledge of the item giving rise to the deficiency. ^[41]   The innocent spouse in Mitchell misreported her deceased husband’s taxable retirement distributions on a joint return, relying on her tax advisor’s opinion that the amount of the retirement distribution treated as taxable on the return was correct.  There was no evidence that the innocent spouse knew the return was incorrect. ^[42]   The Tax Court denied relief because  she had an actual and clear awareness of the omitted income, knew when the transfer refund distribution was received, and the amount of the distribution.  Lack of knowledge of the tax consequences arising from the transfer refund distribution, or that her tax return was incorrect did not meet the Cheshire standard for lack of actual knowledge. ^[43]

In Martin v. Commissioner ^[44] , the taxpayer successfully claimed allocation of deficiency relief under section 6015(c).  The Martin case involved the misreporting of income realized from a failed section 351 transaction.  The IRS argued that the taxpayer had knowledge of the transaction - the sale of real property and the receipt of stock - and should therefore be denied relief.  The Tax Court held that the taxpayer’s minimal and superficial knowledge about the details of the failed 351 transaction did not constitute “actual knowledge of the amount of the financial gain that was misreported, nor of the underlying facts that gave rise to the gain.” ^[45]   The omitted income in Martin was a “paper” gain generated from a transaction consisting of a complex series of steps that was structured to qualify for nonrecognition treatment under section 351.  Neither the taxpayer nor her spouse received any lump sum distribution of cash or other property.

Similarly, the Tax Court, in Charlton v. Commissioner, ^[46] found that the taxpayer qualified for relief under section 6015(c) because he did not have actual knowledge that income generated from his wife’s business was omitted from the return.  The Tax Court found that the taxpayer should have known that income was omitted from the return because he had unfettered access to the financial records of his wife’s business, including bank statements and expense ledgers.  The taxpayer, however, did not verify the income and expenses.  Hence, although the taxpayer should have known of the omitted income, the IRS failed to show that he had actual knowledge of the income item giving rise to the deficiency. ^[47]  

Accordingly, the Tax Court, in omitted income cases under section 6015(c), is currently applying the “actual and clear awareness” standard to determine whether the innocent spouse had actual knowledge of the item giving rise to the deficiency.  This standard seems to conflict with the legislative history of the statute, which implies the knowledge standard requires the Service to prove that an innocent spouse know that an item on his or her return is incorrect in order to deny relief.  Under the Tax Court’s current standard, however, it appears that the IRS must prove that the taxpayer was aware of the amount, source, and date of receipt of the income to prove actual knowledge and prevent innocent spouse relief.

With respect to understatements of tax resulting from disallowed deductions, the Tax Court held that the knowledge standard under section 6015(c) requires the Service to prove that the taxpayer had actual knowledge of the factual circumstances which made the item unallowable as a deduction. ^[48]   “[A]ctual knowledge does not include knowledge of the tax laws or knowledge of the legal consequences of the operative facts.” ^[49]   For example, in King v. Commissioner, the Tax Court held that the taxpayer was eligible for allocation of deficiency relief under section 6105(c) because the IRS did not prove that she had actual knowledge that her ex-husband’s cattle-raising activity lacked the requisite profit motive necessary for a valid deduction. ^[50]

Even when there is actual knowledge of the item giving rise to a deficiency, if the taxpayer can prove that the return was signed under duress, section 6015(c)(3)(C) allows the taxpayer relief from liability. ^[51]   In In re Hinckley, ^[52] the Bankruptcy Court determined that because of her husband’s mental illness, Ellen Hinckley could not resist her husband’s demands, and that she would not have willingly signed the returns without the income included but for his constraints on her will. ^[53]

The second part of this article will review the equitable portion of the new law under section 6015(f), the proposed regulations, IRS procedures in submitting a claim for innocent spouse relief, and the conclusion on whether innocent spouse relief is being granted as Congress envisioned.

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