Liability for Tax Underpayments, Penalties, and Interest: Relief for the “Innocent” Spouse
The tax code does provide means by which a spouse can be relieved of this joint and several obligation. As you can imagine, these exceptions are technical and very fact specific. Recently, the U.S. Tax Court issued two rulings on one of those exceptions: the relief for the innocent spouse. In one case, relief was granted; in the other, relief was denied. What separated these cases?
Essentially, what separated these cases was the IRS’s ability to prove that the spouse requesting relief had actual knowledge, or should have known, that a misrepresentation was being made. In the first case, the couple separated in 2014 and divorced in 2016. The return at issue was filed in 2014 and did not include an IRA distribution that was deposited into their joint checking account. Although they were living separately at the time, the couple continued to use a joint checking account for all purposes until their eventual divorce. Both had access to this account and regularly made transactions from the account. For tax purposes, they sent their information separately to a third-party preparer. However, the ex-wife was generally responsible for any information related to her inherited IRA.
In granting the relief to the ex-husband, the Tax Court held that no evidence existed that he had actual knowledge that a distribution from the account occurred. The Tax Court acknowledged that the ex-husband was generally aware of the account and previous distributions, and that the withdrawal at issue was large enough (when compared to the average account balance) that he should have noticed. However, there was no evidence that the ex-wife specifically informed him that she withdrew money, or that he reviewed the bank records before the joint return was filed.
On the other hand, the Tax Court denied relief for an ex-wife when it held that sufficient evidence existed to show she knew about the understatement when the return was filed. In this case, during the twilight of their marriage, the ex-husband received distributions from his employer’s retirement plan. He also opened credit cards, racked up charges that went unpaid, and eventually received cancellation of debt income. The tax return in question was filed in 2013, about one year before the marriage finally ended in divorce. At trial, the ex-wife testified that during their 20-year marriage, the ex-husband had always handled the couple’s tax filings due to his background in banking and finance. She also stated that the 2013 joint return was presented to her on April 14, 2014, one day before it was due. While she looked it over and noticed it reflected a refund, she did not notice that the retirement income and cancellation of debt income were not included.
In rejecting her argument, the Tax Court pointed out that the cancellation of debt income was reported on Form 1099-C. The ex-spouse received several of these around the end of 2013. In fact, it was these Forms that made her aware of the credit card accounts. Furthermore, near the end of 2013, the ex-wife signed a notarized waiver allowing her ex-husband to take future distributions without her consent. While he did not take a distribution at that time, the ex-wife should have been aware that he could take a distribution at any time. Moreover, the couple received a Form 1099-R reporting the distribution before the 2013 return was filed. In light of the foregoing, the Tax Court denied the relief and held the two jointly and severally liable for the tax debt.
The key takeaway from these cases is communication, or the lack thereof. Spouses that file joint returns should work together when filing a return instead of passing the buck to one party. Even if the couple uses a third-party preparer, they should gather all of the information and review it together before sending it off. Obviously, this might be hard to do when a relationship is its last throes. However, given the wide reaching implications, communication is essential.