How do innocent spouses spell relief

Divorcing spouses frequently engage valuation experts to help divide their assets, particularly when the marital estate includes a private business interest. Not only does closely held stock complicate divorce proceedings, but it also provides opportunities for owners to underreport income or exaggerate expenses.

Dual incentives - A lower bottom line benefits a moneyed spouse in two ways. First, to the extent that a company’s value is based on its earnings, reduced income lowers value. Therefore, low profits increase a moneyed spouse’s share of the estate’s remaining assets. Some moneyed spouses will even hide physical assets or use fraudulent accounting tactics to lower profits reported before their divorces.

Beyond divorce proceedings, some private companies routinely minimize earnings to reduce their tax liabilities. When businesses operate as partnerships or S corporations, business income flows through to the owners’ personal tax returns.

When the IRS uncovers tax deficiencies on a joint tax return, the government can pursue both spouses jointly or either spouse individually to collect the entire liability, regardless of which spouse is responsible for the error. In many instances, IRS attack occurs long after a divorce has been finalized.

Joint liability often seems unfair, especially in the aftermath of a difficult divorce. For instance, many non-moneyed spouses are unaware of their former spouses’ tax avoidance schemes. Others simply received no benefit from the hidden income or lack the financial wherewithal to pay the entire liability.

Expanded innocent spouse rules - Fortunately, Congress recently acknowledged this inequity and expanded the innocent spouse rules. Under the IRS Restructuring Act of 1998, innocent spouses now have three options to relieve them of a joint tax liability:

1. Innocent spouse relief — Internal Revenue Code (IRC) Section 6015(b) - As with previous regulations, if a spouse can prove that he or she did not know or have reason to know of a tax understatement, the IRS may relieve the innocent spouse of the tax liability.

Understatements occur when the IRS discovers that income or revenue has been omitted, or when expenses, itemized deductions or credits have been exaggerated. But current law cannot relieve innocent spouses from underpayments, which occur when the parties have not yet paid a tax bill.

Innocent spouse relief is not a new concept and was formerly granted under IRC 6013(e). But the revised code eliminates the size limitations on eligible understatements and relaxes the standard required to assert innocence.

2. Separation of liability — IRC Section 6015(c) - Divorced taxpayers can also elect to separate tax deficiencies (but not tax underpayments) based on the portion for which they are directly responsible. To be eligible for this form of relief, the electing spouse must not have actual knowledge of the understatement.

This election only limits the tax burden for the spouse making the election. If the other party fails to make a similar filing, he or she will remain liable for the entire joint tax bill. To avoid unpleasant surprises, divorcées may want to consider automatically petitioning to separate their joint tax liabilities under IRC Section 6015(b).

3. Equitable relief — IRC Section 6015(f) - If neither of the previous two methods relieves a spouse from an inequitable tax burden, the taxpayer can throw himself or herself on the mercy of the IRS. But keep in mind that the Tax Court has no jurisdiction over equitable relief claims.

Under this option, the IRS may forgive both tax understatements and underpayments. In addition to the petitioning spouse’s knowledge of errors and underpayments, the IRS considers whether the spouse benefited from an understatement. It also considers whether the spouse can afford to pay his or her basic living expenses after paying the tax deficiency.

Taxing issues - Most valuators don’t actually prepare tax returns for their divorcing clients. But taxes often play a key role in splitting up the parties’ estate and formulating maintenance payments. To best serve their clients’ needs, valuators who specialize in divorce have an in-depth understanding of tax issues, including the new innocent spouse rules.

Current tax law alters the balance of power between divorce courts and the Tax Court. The Tax Court has jurisdiction to review the IRS’s assessment of a spouse’s innocence. Consequently, Tax Court proceedings may resemble divorce hearings.

For instance, the IRS must inform the non-petitioning spouse of any innocent spouse claims and allow the non-petitioning spouse to present his or her side of the argument.

Divorced couples often have divergent views on the issues used to evaluate innocence, such as the non-moneyed spouse’s benefit from an understatement or his or her involvement in the business. So Tax Court trials may rehash many of the same issues that the divorce court addressed.

Implications of testimony - Remember, too, that testimony in divorce court may come back to haunt both parties. For example, suppose a non-moneyed spouse, desperate to increase support payments, alleges that the business owner historically omitted cash receipts from the couple’s joint tax return. Such testimony could subsequently be used against the petitioning spouse in determining innocent spouse relief.

Clients, attorneys and valuators need to be aware of current tax law and its implications to ensure the best outcomes in marital dissolution cases.

Sidebar: What did they know and when did they know it?

Here are some questions the IRS may use to assess whether a spouse knew or had reason to know of an understatement:

• What was the nature and relative size of the error?
• What are the spouses’ current and former financial situations?
• Did the petitioning spouse benefit directly or indirectly from the understatement?
• What are the petitioning spouse’s levels of education and business acumen?
• What was the petitioning spouse’s degree of participation in the activity related to the erroneous item?
• Would a reasonable person have questioned the erroneous item when signing or reviewing a joint tax return?
• Was the error a departure from the parties’ previous tax reporting practices?

The answers to these questions can help determine whether the petitioning spouse is liable for the erroneous tax information.