Tax Relief for Injured and Innocent Spouses
By filing “a single return jointly of income taxes,”1 instead of two “married filing separately” returns, married taxpayers usually reduce their preparation expenses and federal income taxes.2 One cost offsetting those savings is that any overpayment of tax on a joint return that is encumbered by certain premarital debts of either spouse. Another cost is the joint and several liability3of each spouse for taxes due on the joint returns they signed. Here are fifteen ways that California and federal tax law can reduce, or even eliminate, those taxes and costs for injured and innocent spouses.
II. Injured Spouses
A spouse is an “injured spouse” if he or she files a joint tax return that shows taxes were overpaid, and then has some or all of his or her share of that overpayment “offset,” by the IRS, to pay certain of her spouse’s debts that were incurred before their marriage. Those debts include legally enforceable: unpaid federal or state tax, plus interest, penalty, or other addition to such tax;4 child or spousal support;5 debts (including student loans) owed to another federal agency;6 overpayments of Old Age, Survivors and Disability Insurance benefits;7state income taxes;8 and certain overpayments of state unemployment compensation.9
To prevent the taking of an injured spouse’s share of federal tax overpayments, he or she must complete a Form 8379 and attach it to each and every federal joint income tax return he or she files. That same form can be used to make a refund claim. Unfortunately, “California does not have an injured spouse provision.”10
To illustrate, assume that Greta Clew married Joe Kerr in 2013. In September 2014, they filed a joint 2013 United States income tax return, which showed that they had overpaid their federal income taxes by $8,000. Last week, they received a notice from the Internal Revenue Service11 that their federal overpayment would be applied to Joe’s unpaid child support. By filing a Form 8379, Greta can get $4,000 of that 2013 overpayment back from the IRS. Further, if Greta attaches a new Form 8379 to each of the Kerrs’ future joint 1040s, then she will get a refund equal to half of each year’s overpayment.
III. Innocent Spouses
The Internal Revenue Code recognizes three types of “innocent spouse”: A spouse who filed a joint return and then discovered that his or her spouse has omitted income from, or falsely claimed deductions or credits on, that return; a spouse who signed a joint return that understated the tax owed and is now divorced, legally separated from, or no longer living with her/his co-filer; and a spouse whom it would be inequitable to hold liable for a tax owed on a joint return they filed. California law virtually copies federal law regarding tax relief for those three types of innocent spouses and will accept an IRS determination as final for state purposes.12 California also authorizes California courts, in limited circumstances, to revise the joint California income liabilities of a divorcing couple.13
Any innocent spouse can obtain relief from any tax, interest, penalty, or other amount owed on a filed joint return14 because his or her spouse failed to report income, or wrongly reported a property’s basis, a tax credit or a deduction.15 To qualify for “section 6015(b)” relief from both the IRS and the FTB, he or she must timely file Form 8857 with the IRS, and FTB Form 705 with the FTB, no later than two years after the date that the relevant agency began collection activities against the innocent spouse.16 He or she must then establish that, when he or she signed the return in question, he or she did not know, or had no reason to know, of his or her spouse’s misstatement17 and that, “taking into account all the facts and circumstances, it is inequitable to hold” him or her liable for the understatement of tax on that return.18
The second form of “innocent spouse” relief is available to those joint filers who are now divorced,19 legally separated, or have not lived in the same household during the past 12 months.20 As with section 6015(b) relief, an innocent spouse must elect section 6015(c) relief within two years of the IRS’s commencement of collection activities against that individual.21
However, unlike section 6015(b) relief, section 6015(c) relief is limited to an allocation of each item “giving rise to a deficiency on a joint return . . . in the same manner as it would have been allocated if the individuals had filed separate returns for the taxable year.”22 Further, the IRS may limit this form of relief if the IRS “demonstrates that assets were transferred between individuals filing a joint return as part of a fraudulent scheme”23 or “if the principal purpose of the transfer was the avoidance of tax or payment of tax.”24
Consider the following example of how these first two forms of “innocent spouse” relief work, and don’t work: On June 16, 2008, Cameron and Mitchell became one of the first same-sex couples to legally marry in California. In 2009, they timely filed joint state and federal income tax returns for 2008. Those returns included Schedules C reporting Mitchell’s income, and other items, from his solo law practice. When the IRS audited their 2008 and 2009 returns, Mitchell told Cam: “Don’t worry: I’ll take care of it.” Other than occasionally signing documents prepared by Mitchell, Cam heard nothing more about the audit until this week, when he opened a letter from the IRS and read that he owes $100,000+ on those returns. He calls you to discuss these matters. During that discussion, he tells you that he and Mitchell are still very happy together and want to stay married.
Unfortunately, even if all of the deficiencies assessed by the IRS are due to solely to Mitchell understating his Schedule C income, Cam cannot qualify for section 6015(b) innocent spouse relief unless he can show that he did not know, and had no reason to know, about those understatements when he signed their 2008 and later returns and that it would be unfair to hold him liable for Mitchell’s understatements. Further, Cam does not qualify for section 6015(c) relief because he and Mitchell are still married and living together.
If a spouse does not qualify for either section 6015(b) or section 6015(c) relief, then the last innocent spouse refuge available is “equitable relief” under section 6015(f). To determine “when, considering all the facts and circumstances, it would be inequitable to hold the requesting spouse jointly and severally liable,”25 the IRS will use, among others, the factors currently set forth in Revenue Procedure 2013-34.26
Among the factors that will weigh in favor of section 6015(f) equitable relief are whether the requesting spouse: is no longer married to the nonrequesting spouse;27 would suffer economic hardship if relief is not granted;28 had no knowledge or reason to know, as the date the return was filed, of the items giving rise to the deficiency or “that the nonrequesting spouse would not or could not pay the tax liability . . . within a reasonable period of time after the filing of the return,”29 was abused by the nonrequesting spouse;30 or “is in poor physical or mental health.”31 The factors weighing against equitable relief include that the requesting spouse: “has a legal obligation to pay the outstanding Federal tax liability [such as] a divorce decree or other legally binding agreement,”32 “significantly benefitted from the unpaid income tax liability or understatement,”33 and “has not made a good faith effort to comply with the income tax laws in the taxable years following the tax year or years” covered by his or her request for relief.34
The good news is that, unlike for the two-year statute of limitations for electing relief under section 6015(b) and (c), an innocent spouse can apply for section 6015(f) equitable relief at any time before the “collection statute of limitations”35 expires or, if applicable, the expiry of the section 6511 period of limitation for credit or refund of overpaid taxes.36
Here is an example illustrating how section 6015(f) works: Wanda was married to Harry until his death in prison in 2011. During their marriage, he embezzled, without Wanda’s involvement or knowledge, over $10,000,000 from investors in his Ponzi schemes. Harry spent most of that on gambling, drugs, and women, including Wanda. In 2009, after the money ran out, Harry pled “guilty” in return for a sentence of only 10 years. While Harry was in prison, the IRS and the FTB assessed over $5,000,000 in taxes, penalties and interest against him and Wanda for failing to report that embezzlement income on their joint tax returns. Wanda has been referred to you for innocent spouse relief.
Wanda should complete a Form 433-A to determine if she has any asset that would be lost in a bankruptcy. If she does, then file a completed Form 8857 and she may get partial equitable relief under section 6015(f). However, she would probably get relieved of her joint tax burdens more quickly, and less expensively, by filing for bankruptcy.37
Finally, in a California proceeding for dissolution of the marriage of a “husband and wife,” California courts are authorized to “revise” their joint and several liability, for California income taxes owed on California joint returns, by court order.38 However, such an order “may not relieve a spouse of tax liability on income earned by or subject to the exclusive management of the spouse.”39 Instead, a spouse’s liability for the tax, penalties and interest for a tax year must be pro rata with the share of the couple’s total income that is earned, or managed and controlled, by that spouse.40 Further, the court order: must specify the spouses’ separate income tax liabilities for specific tax years;41 may only revise liabilities that are unpaid; 42 only becomes “effective when the Franchise Tax Board is served with or acknowledges receipt of the order;”43 and is not effective “if the gross income reportable on the return exceeds [$150,000, or if either spouse’s tax relief exceeds $7,500], unless a tax revision clearance certificate is obtained from the [FTB] and filed with the court.”44
IV. Relief from Community Property Tax Liabilities
In general, a married taxpayer owns half of his or her spouse’s earned income,45 if that income is subject to community property laws.46 Earned income includes “wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered . . . .”47 Earned income also includes “a reasonable allowance as compensation for the personal services rendered by the [taxpayer’s spouse], not in excess of thirty percent of his share of the net profits of [a] trade or business” in which both personal and capital are material income-producing factors.48
Internal Revenue Code section 66(a) states that, if a taxpayer: is married at any time during a calendar year;49 but the married couple “live[s] apart at all times during the calendar year;”50 does not file a joint return with each other for that year;51and the taxpayer’s spouse does not transfer any of his or her community income to the taxpayer during that year, then such income “shall be treated in accordance with the rules provided by section 879(a).”52 One of the rules of section 879(a) is that: “Earned income (within the meaning of section 911(d)(2)) . . . shall be treated as the income of the spouse who rendered the personal services.”53
As an example of section 66(a) relief, assume that, in 2010, Fred took a job in San Francisco, leaving Wilma and the children in their Pasadena home. They filed joint tax returns for 2010 and 2011. In August 2012, Wilma filed for divorce and her marriage was terminated in March 2014 so that Fred could remarry. Wilma filed her returns as a “head of household” in 2012 and 2013. Recently, the IRS began an audit of Wilma’s 2012 and 2013 returns based on Fred’s insistence that Wilma should pay tax on half of his earned income in those years. Under section 66(a), Wilma must pay federal income tax on half of Fred’s earned income until they became estranged. Also, to qualify for the more favorable “head of household” tax rates, Wilma must prove, among other things,54 that Fred was not a member of that household during the last six months of each tax year.55
If a taxpayer does not qualify for section 66(a) relief, then section 66(b) allows the IRS to grant relief if the taxpayer’s spouse “acted as if [he or she were] solely entitled to [community earned] income and failed to notify the taxpayer … before the due date (including extensions) for filing the return for the taxable year in which the income was derived of the nature and amount of such income.”56 California tax law offers the same taxpayer the same relief on his or her California income tax return.57
To continue with the previous example: Assume that Wilma can show that the reason she filed for divorce was that Fred stopped sending her any of his earnings after November 2011 and never sent her a copy of either of his W-2s for 2012 or 2013. On the other hand, Fred did send their children Christmas and birthday gifts, some of which were cash, and sometimes sent her grocery money. Facts like those would support the argument that Fred acted as if he were solely entitled to his earned income as early as 2011 and that he and Wilma were estranged before 2012. Even the occasional gift of cash does not hurt, as the IRS has stated that de minimis transfers of earned income do not violate section 66.58 Thus, Wilma can argue that she was justified in excluding all of Fred’s 2012 earned income from her separate federal tax return for that year.
Even if a taxpayer does not qualify for relief under either section 66(a) or section 66(b), he or she will still receive relief from the income taxes resulting from the operation of community property laws if he or she did not file a joint return for the taxable years for which he or she seeks relief;59 he or she included, in his or her gross income for such taxable years, an item of community income that, pursuant to section 879(a), would be treated as the income of the nonrequesting spouse;60 the requesting spouse proves that he or she “did not know of, and had no reason to know of, such item of community income;”61 under “all facts and circumstances, it would be inequitable to include such item of community income” in his or her gross income;62 and he or she timely files a Form 8857 requesting such relief.63
If a spouse does not qualify for relief under section 66(a), section 66(b), or the traditional relief accorded by section 66(c), then equitable relief may still be available if “it is inequitable to hold the requesting spouse liable for the unpaid tax or deficiency (or any portion of either) . . . .”64 The factors relevant to such relief are identical to the factors relevant to equitable relief for innocent spouses under section 6015(f).65 On the other hand, the filing deadline differs; a Form 8857 requesting equitable relief under section 66(c) cannot be filed before “the requesting spouse receives notification of an audit or notice from the IRS stating that there may be an outstanding liability with regard to that year . . . .”66
This paper has examined fifteen forms of California and federal relief available to injured and innocent spouses. Please consult with a tax professional before applying for any of them. ■
* My thanks to Karl Swaidan, Hratch Karakatchian, and the attendees at the October 2014 meeting of the Pasadena Bar Association’s Tax Section, for their comments on earlier drafts.
1 Joint returns are authorized by section 6013 of the Internal Revenue Code (hereinafter, “I.R.C.”), which is title 26 of the United States Code (“U.S.C.”)
2 Cf. I.R.C. § 1(a) with I.R.C. § 1(d); see Whittington, Leslie A., Marriage Penalty, http://www.urban.org/books/TTP/whittington.cfm (last visited July 3, 2014.).
3 I.R.C. § 6013(d)(3); Cal. Rev. & Tax. Code § 19006(b).
4 I.R.C. § 6402(a) ; Treas. Reg. § 301.6402-1; Cal. Rev. & Tax. Code § 19301(b).
5 I.R.C. § 6402(c ); Treas. Reg. § 301.6402-5; 31 CFR §§285.1, 285.3 ; contra Cal. Rev. & Tax. Code § 19301 (California’s Franchise Tax Board (“FTB”) is not authorized to withhold an income tax overpayment because of such a debt).
6 I.R.C. § 6402(d); 31 U.S.C. § 3720A(a) ;(31 CFR §285.2; Treas. Reg. § 301.6402-6; contra Cal. Rev. & Tax. Code § 19301 (The FTB is not authorized to withhold an income tax overpayment because of such a debt).
7 I.R.C. § 6402(d)(3); 31 U.S.C. §§ 3720A(f); contra Cal. Rev. & Tax. Code § 19301.
8 I.R.C. § 6402(e); 31 CFR §285.8; see also Cal. Rev. & Tax. Code § 19291(a) (allowing the FTB to collect and pay over delinquent taxes owed to the IRS and to any state with a reciprocal agreement to collect taxes owed to the FTB).
9 I.R.C. § 6402(f)(1); contra Cal. Rev. & Tax. Code § 19301.
10 FTB, 705 booklet (rev’d 01-2011) at 2.
11 Hereinafter, the “IRS”.
12 Thus, a taxpayer who has applied for federal innocent spouse relief may simply attach a copy of that application, i.e., Form 8857, to his or her FTB application , i.e., Form FTB 705, and then pursue only his or her federal application.
13 Cal. Rev. & Tax. Code § 19006; see http://ftb.ca.gov/individuals/faq/InnocentSpouse (last visited Oct. 15, 2014).
14 I.R.C. § 6015(b)(1)(A); Cal. Rev. & Tax. Code § 18533(a)(1)(A).
15 See I.R.C. § 6015(b)(1)(B); Cal. Rev. & Tax. Code § 18533(b)(1)(B).
16 I.R.C. § 6015(b)(1)(E); Cal. Rev. & Tax. Code § 18533(b)(1)(E).
17 I.R.C. § 6015(b)(1)(C); Cal. Rev. & Tax. Code § 18533(b)(1)(C).
18 I.R.C. § 6015(b)(1)(D); Cal. Rev. & Tax. Code § 18533(b)(1)(D).
19 I.R.C. § 6015(c)(3)(A)(i)(I); Cal. Rev. & Tax. Code § 18533(c)(3)(A)(i)(I). NB: A spouse’s death is treated as a divorce. Treas. Reg. § 1.6015-3(a).
20 I.R.C. § 6015(c)(3)(A)(i)(II); Cal. Rev. & Tax. Code § 18533(c)(3)(A)(i)(II). NB: Where one spouse is in prison and the other spouse maintains a household in anticipation of his return, the spouses will be considered as members of the same household. Treas. Reg. § 1.6015-3(b)(3)(i).
21 I.R.C. § 6015(c)(3)(B); Cal. Rev. & Tax. Code § 18533(c)(3)(B).
22 I.R.C. § 6015(d)(3); Cal. Rev. & Tax. Code § 18533(d)(3). However, the disallowance of items of deduction or credit “solely because a separate return is filed . . . shall be disregarded and the items shall be computed as if a joint return had been filed and then allocated between the spouses appropriately.” I.R.C. § 6015(d)(4); Cal. Rev. & Tax. Code § 18533(d)(4). Also, a child’s tax liability “included on a joint return . . . shall be disregarded in computing the separate liability of either spouse and such liability shall be allocated appropriately between the spouses.” I.R.C. § 6015(d)(5); Cal. Rev. & Tax. Code § 18533(d)(5).
23 I.R.C. § 6015(c)(3)(A)(ii); Cal. Rev. & Tax. Code § 18533(c)(3)(A)(ii).
24 I.R.C. § 6015(c)(4)(B)(i); Cal. Rev. & Tax. Code § 18533(c)(4)(B)(i).
25 Treas. Reg. § 1.6015-4(a).
26 Rev. Proc. 2013-34, 2013-43 I.R.B. (Oct. 21, 2013).
27 Rev. Proc. 2013-34, 2013-43 I.R.B. at 400, § 4.03(2)(a). “No longer married” means the requesting spouse is: under applicable state law, divorced, or legally separated from the nonrequesting spouse; “a widow or widower and is not an heir to the nonrequesting spouse’s estate that would have sufficient assets to pay the tax liability;” or “has not been a member of the same household as the nonrequesting spouse at any time during the 12-month period ending on the date the Service makes its determination.”
28 Rev. Proc. 2013-34, 2013-43 I.R.B. at 401, § 4.03(2)(b).
29 §§ 4.03(2)(c)(i)-(ii); see Rev. Proc. 2013-34, 2013-43 I.R.B. at 402, §4.03(c )(iii), for some of the factors that determine whether the requesting spouse had “reason to know” of the nonrequesting spouse’s understatement, or underpayment, of tax.
30 Rev. Proc. 2013-34, 2013-43 I.R.B. at 402, § 4.03(2)(c)(iv).
31 Rev. Proc. 2013-34, 2013-43 I.R.B. at 403, § 4.03(2)(g).
32 § 4.03(2)(d).
33 § 4.03(2)(e).
34 § 4.03(2)(f).
35 I.R.C. § 6502; Cal. Rev. & Tax. Code § 19057.
36 Rev. Proc. 2013-34, 2013-43 I.R.B. at 399, § 4.01(3).
37 See 11 U.S.C. (the “Bankruptcy Code”).
38 Cal. Rev. & Tax Code § 19006(b). Note that California courts do not have jurisdiction to revise a divorcing couple’s liability for federal income taxes.
39 § 19006(b).
40 § 19006(b)(1).
41 § 19006(b)(2)(A).
42 § 19006(b)(2)(B)
43 § 19006(b)(2)(C).
44 § 19006(b)(2)(D).
45 I.R.C. § 66(d)(1) (“The term ‘earned income’ has the meaning given to such term by section 911(d)(2)”).
46 § 66(d)(3) (“The term ‘community property laws” means the community property laws of a state, a foreign country, or a possession of the United States.”) The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. I.R.S., Instructions For Form 8379 (rev’d Nov. 2012) at 1, col. 3.
47 I.R.C. § 911(d)(2)(A).
48 § 911(d)(2)(B).
49 § 66(a)(1).
50 § 66(a)(2)(A). “Living apart” means the spouses are estranged and maintaining separate residences. Treas. Reg. §§ 1.66-2(b), 1.6015-3(b)(3)(ii).
51 I.R.C. § 66(a)(2)(B). Thus, the standard tax attorney advice to divorcing spouses is: Do not sign a joint return.
52 § 66(a) (flush language). Note bene: California tax law does not offer section 66(a)-style relief.
53 § 879(a)(1).
54 See I.R.C. §§ 2(c), 7703.
55 See § 7703(b)(3).
56 § 66(b).
57 Cal. Rev. & Tax Code § 18534(b).
58 Treas. Reg. §§ 1.66-2(c), (d) ex. 2.
59 I.R.C. § 66(c)(1); Cal. Rev. & Tax Code § 18534(a)(1)).
60 I.R.C. § 66(c)(2); Cal. Rev. & Tax Code § 18534(a)(2) (which does not mention section 879(a).
61 I.R.C. § 66(c)(3); Cal. Rev. & Tax Code § 18534(a)(3).
62 I.R.C. § 66(c)(4); Cal. Rev. & Tax Code § 18534(a)(4).
63 Treas. Reg. § 1.66-4(j)(1). A Form 8857 requesting traditional relief may not be filed before “the requesting spouse receives notice of an audit or letter or notice from the IRS stating that there may be an outstanding liability with regard to” a separate return he or she filed. The latest such a request may be made “is 6 months before the expiration of limitations on assessments, including extensions, against the nonrequesting spouse for the taxable year that is the subject of the request unless the examination of the requesting spouse’s return commences during that 6-month period.” In the latter case, the Form 8857 must be filed within “30 days after the commencement of the examination.” § 1.66-4(j)(2).
64 I.R.C. § 66(c) (last sentence of flush language); Cal. Rev. & Tax Code § 18534(a) (last paragraph).
65 See supra text accompanying notes 25-36.
66 Treas. Reg. § 1.66-4(j)(2)(ii)