Husband and Wife have always filed joint income tax returns. Wife is concerned that there may be future liability if the IRS audits any of the joint returns. As part of the settlement negotiations, Wife insists on the following provision protecting her against future assessments.

Husband shall fully indemnify, defend, and hold Wife harmless from all taxes, penalties, and interest arising out of, or related to, any examination of any joint income tax return previously filed by Husband and Wife.

Wife may have recourse in the courts but is not immune from future IRS collection attempts. Having filed joint returns, Wife is jointly and severally liable for any omissions or errors on the tax returns. The IRS does not have to abide by the provision in the settlement agreement and may attempt to collect any deficiency from either party.

However, Wife may be relieved of responsibility for paying tax, penalties, and interest under one of three innocent spouse provisions of Internal Revenue Code 6015. Wife must provide information regarding her knowledge of the erroneous items, her involvement in family finances, her current financial situation, and other relevant information, by filing Form 8857 and meeting the qualifications for one of the three types of relief.

INNOCENT SPOUSE RELIEF – You can be relieved of responsibility for paying tax, interest, and penalties if your spouse (or former spouse) improperly reported items or omitted items on your tax return if all of the following conditions apply:

1. You must have filed a joint return which has an understatement of tax.
2. The understatement of tax must be due to erroneous items of your spouse (or former spouse). Erroneous items include any gross income item received by your spouse that is not reported and improper deductions, credits, or property basis claimed by your spouse (or former spouse).
3. You must establish that, at the time you signed the return, you did not know, and had no reason to know, that there was an understatement of tax.
4. Taking into account all the facts and circumstances, it would be unfair to hold you liable for the understatement of tax.
5. You must file for relief within 2 years after the date on which the IRS first began collection activity against you.

SEPARATION OF LIABILITY RELIEF – Under this type of relief, you divide the understatement of tax on your joint return between you and your spouse. The qualifications for this type of relief are as follows:

1. You must have filed a joint return.
2. You are no longer married to, or are legally separated from, the spouse with whom you filed a joint return; or
3. You were not a member of the same household as the spouse with whom you filed the joint return at any time during the 12 month period ending the date you file Form 8857 requesting relief.
4. You did not have actual knowledge of the erroneous item.
5. You and your spouse did not transfer assets for the main purpose of avoiding payment of tax.

Example: Husband and Wife filed a joint return reporting Wife’s wages of $50,000 and Husband’s self-employment income of $30,000. Following an audit, the IRS assessed additional taxes, penalties, and interest based on Husband’s failure to report another $50,000 of self-employment income and the failure to report interest from joint investments. Because the IRS was able to prove that Wife actually knew of the additional income at the time she signed the joint return, the IRS can collect the total deficiency attributable to the understatement from either party.

Absent proof of the Wife’s actual knowledge of the understatement, the IRS could only collect the deficiency attributable to the self-employment income from Husband while Wife remained jointly and severally liable for the deficiency attributable to the interest from the joint investments.

EQUITABLE RELIEF – You may qualify for equitable relief if you do not qualify for innocent spouse relief or separation of liability relief. Unlike innocent spouse relief or separation of liability, it is possible to obtain equitable relief from either an understatement of tax or an underpayment of tax. An underpayment of tax is an amount of tax that you properly reported on your tax return but that you have not paid. To qualify for equitable relief, you must meet all of the following requirements.

1. You are not eligible for innocent spouse relief or separation of liability relief.
2. You have an understated tax or an underpaid tax.
3. You did not pay the tax.
4. You establish that taking all the facts and circumstances into account, it would be unfair to hold you liable for the understated or underpaid tax.
5. You and your spouse or former spouse did not transfer assets to one another as part of a fraudulent scheme.
6. Your spouse (or former spouse) did not transfer property to you for the main purpose of avoiding tax.
7. You did not file (or fail to file) with the intent to commit fraud.
8. The income tax liability from which you seek relief must be attributable to an item of the spouse (or former spouse) with whom you filed the joint return, with certain limited exceptions, including:

•  If the item is titled in your name, the item is presumed to be attributable to you. However, you can rebut this presumption based on the facts and circumstances.
• You did not know, and had no reason to know that funds intended for the payment of tax were misappropriated by your spouse (or former spouse) for his or her benefit. If you meet this exception, the IRS will consider granting equitable relief although the underpaid tax may be attributable in part or in full to your item, and only to the extent the funds intended for payment were taken by your spouse (or former spouse).
• You establish that you were the victim of domestic violence, and that as a result of the prior abuse; you did not challenge the treatment of any items on the return for fear of your spouse’s retaliation. If you meet this exception, relief will be considered even though the understated tax or underpaid tax may be attributable in part or in full to your item.

What factors does the IRS consider in determining whether to grant equitable relief?

Were you separated or divorced from your spouse? A temporary absence is not considered separation for this purpose. A temporary absence is one where it is reasonable to assume that the absent spouse will return to the household.

Were you the victim of spousal abuse or domestic violence before signing the return? Even if you had actual knowledge, you may still qualify for relief if you establish that your were the victim of domestic abuse before signing the return and because of that abuse, you did not challenge the treatment of any items on the return because you were afraid your spouse (or former spouse) would retaliate against you. If you establish that you signed your joint return under duress, then it is not a joint return, and you are not liable for any tax shown on that return or any tax deficiency for that return. However, you may be required to file a separate return for that year.

Were you in poor mental or physical health on the date you signed the return or at the time you requested relief?

Would you suffer a significant hardship if relief is not granted?
A significant hardship means that you would not be able to pay your reasonable basic living expenses.

Do you have a legal obligation under a divorce decree or agreement to pay the tax? This factor will not weigh in favor of relief if you knew or had reason to know, when entering into the divorce agreement, that your former spouse would not pay the income tax liability.

Did you receive a significant benefit (beyond normal support) from the underpaid tax or the item causing the understated tax?

Did you make a good faith effort to comply with federal income tax laws for the tax year for which you are requesting relief or the following years?

Did you have reason to know about the items causing the understated tax or that the tax would not be paid? The IRS may consider whether you made a deliberate effort to avoid learning about the item in order to be shielded from liability or whether you and your spouse (or former spouse) jointly owned the property that resulted in the erroneous item.

Reason to know of the item giving rise to the understatement will not be weighed more heavily than other factors. Actual knowledge of the item giving rise to the understatement, however, is a strong factor weighing against relief. This strong factor may be overcome if the factors in favor of equitable relief are particularly compelling. In determining whether you had reason to know, the IRS will consider your level of education, any deceit or evasiveness of your spouse (or former spouse), your degree of involvement in the activity generating the income tax liability, your involvement in business and household financial matters, your business or financial expertise, and any lavish or unusual expenditures compared with past spending levels.

Other Considerations – The IRS must contact your former spouse

By law, the IRS must contact your spouse or former spouse. There are no exceptions, even for victims of spousal abuse or domestic violence. Your spouse (or former spouse) will be notified that you filed Form 8857 and will be allowed to participate in the process. If you are requesting relief from joint and several liability on a joint return, the IRS must also inform your spouse (or former spouse) of its preliminary and final determinations regarding your request for relief. However, to protect your privacy, the IRS will not disclose your personal information (current name, address, phone number, current employer, your income or assets) or any other information that does not relate to making a determination about your request for relief from liability.

The non-requesting spouse has the right to appeal the preliminary determination to grant relief or partial relief to the requesting spouse when the preliminary determination letter is issued April 1, 2003 or later (Rev. Proc, 2003-19). However, the non-requesting spouse may not petition the Tax Court from the final determination letter. If relief is denied in full or in part, and the requesting spouse petitions the U.S. Tax Court, the non-requesting spouse will be given the opportunity to become a party in that proceeding.

Final Considerations

The IRS rejects approximately 40% of all claims for innocent spouse relief because the party requesting the relief is ineligible. Innocent spouse relief is designed only for cases where the taxpayer underpaid or understated the tax due, not where the taxpayer paid the tax in full. The IRS will only accept requests for innocent spouse relief after a taxpayer receives a notice of audit or other notification of potential liability. The taxpayer must file the request for innocent spouse relief no later than two years after collection efforts begin. If the IRS denies the petition for relief, the taxpayer then has 90 days to petition the Tax Court.