The IRS will let an “Innocent Spouse” off the hook for unreported taxes created by their not-so-innocent spouse. To qualify the innocent spouse must prove that they:
- had no actual knowledge of the understatement, or
- had no reason to know of the understatement, and
- they received no significant benefit from the under-reported taxes.
As you can guess, proving that you “had no reason to know” can be very subjective. Factors that the IRS will consider include:
- Educational background and business experience.
- The extent to which the spouse participated in the business.
- Whether or not the spouse asked reasonable questions at the time the return was prepared.
- Whether there was a departure from the trends of prior tax returns.
Showing that the innocent spouse received no significant benefit is also problematic. The IRS looks for evidence that the under-reported taxes were transferred to the innocent spouse in some manner. This could be cash or it could be payment of country club dues that were beyond the normal support needed for the spouse.
All these factors are hard to prove definitively, one way or the other. The result is that you need to plan on a trip to Appeals whenever you make this claim.
Joe and Sally file a joint income tax return. Unbeknownst to Sally, Joe has underreported his business income and now she is on the hook for the tax. The answer is to file an Innocent Spouse claim and sever the joint liability. Will it work?
The IRS accepts these claims less than 25% of the time. These claims usually get turned down because the innocent spouse, while not having direct knowledge, should have realized that the reported income was too low. Additionally, he or she benefited from the underpayment of the tax. If the country club dues were $30k and they live in a $500k house while sending their kids to a private school, the idea that the business only produces $50k of income should be obviously wrong to anybody.
The scenario that does get accepted are ones where one spouse not only underreports his or her income but keeps their lifestyle in line with the reported income. Let’s say Joe skims $200k from his business and then hides that money overseas. Sally would have no reason to suspect that the tax return was incorrect and she would have received no benefit from the tax evasion.
Interestingly, there is a situation that can improve Sally’s chance of winning this claim. Innocent Spouse claims require the IRS to notify the other spouse about the claim and the results. Many times, a non-innocent spouse will submit information to the IRS disputing the other spouse’s claim. Inevitably this spouse shows themselves to be such a dick that the innocent spouse claims have a better chance of being accepted because the IRS people develop sympathy for the innocent spouse.
Innocent Spouse Relief is a claim requesting relief from the Joint and Several Liability that accompanies a joint tax return. There are three requirements for this claim to work:
- There must be an understatement of the tax that can be attributed to erroneous items of the other spouse.
- The innocent spouse did not know and had no reason to know about the erroneous items when he or she signed the return.
- It would be inequitable to hold the innocent spouse liable because they did not receive any benefit from the understatement or they were abused.
If the Innocent Spouse Claim is upheld the tax liability is split up between the two parties, usually by calculating two married filing separately returns. The results then are used to allocate a portion of the joint liability to each.
The Innocent Spouse Claim is confused many times with the “Injured Spouse Claim” which is a whole different kettle of fish. An injured spouse is someone who filed joint and had their part of the refund allocated to their spouse’s debt in which they were not liable. Almost always this is the result of a marriage in which one spouse had previous debt.
The Innocent Spouse Claim should also not be confused with fraud. Forged signatures or returns signed under duress are not valid returns. These cases, particularly the ones with forged signatures, have a good chance of being referred for criminal prosecution.
Innocent Spouse Claims are filed using form 8857. The injured spouse must make the claim within 2 years from the start of “significant collection activities”. The date of a notice of intent to levy is the common starting date for filing these claims.