DEALING WITH THE IRS COLLECTION DIVISION

THE NEW “INNOCENT SPOUSE” RULES --
AN UPDATE ON “EQUITABLE” RELIEF ©

Burton J. Haynes, Attorney at Law¹

When we left our friends, Rhett and Scarlett (in the article which appeared in the previous issue of The Free State Accountant), they were contemplating the relief Scarlett could obtain under the new innocent spouse rules enacted by the IRS Restructuring and Reform Act of 1998. In the months since that article was published, there have been several important pronouncements from the IRS interpreting and implementing the new innocent spouse rules. In addition, an important deadline for seeking innocent spouse relief is almost upon us. This article will present what you need to know to stay current on the innocent spouse rules, and to avoid getting stung by the pending deadline.

Review

First a brief review. The point of the innocent spouse rules is to limit the "joint and several liability" which normally results from the filing of a joint income tax return.² The Act added §6015 to the Internal Revenue Code, replacing the old innocent spouse rules found in §6013(e). Two principal forms of relief are available: one for all joint filers, and the other for those who are divorced, or widowed, or separated. In addition, it is also possible to escape liability if the IRS, in its administrative discretion, finds that it would be "inequitable" to hold the taxpayer liable.

The form of relief available to all joint filers, even those who are still married, is found in §6015(b). The requesting spouse will be relieved of liability for a deficiency under the following circumstances:

• A joint return was filed.
  
  
• On that return there was "an understatement of tax attributable to erroneous items" of one spouse. (Note that we are talking here about a deficiency, not simply an amount shown on the face of a joint return not paid.)
  
  
• The innocent spouse establishes that she "did not know, and had no reason to know," of the tax understatement, and that "taking into account all the facts and circumstances, it is inequitable" to hold her liable.
  
  
• The requesting spouse seeks relief in the manner prescribed by the IRS³ within two years of the commencement of collection action against her.

If the requesting spouse is divorced, widowed or separated, relief is even easier to obtain. Under §6015(c) and (d), such a spouse may simply elect to separate responsibility for the deficiency on a "proportional" basis, as though separate returns had been filed in the first place. Any item giving rise to a deficiency is allocated to the appropriate spouse. The election to separate the liability in this fashion must be filed within two years of the time the IRS begins collection action against the spouse seeking relief.

The deadline

From the above recitation of the rules, you have no doubt already spotted the deadline. Act §3201(g)(2) provides that the two year period for filing a claim for relief under either §6015(b) or (c) starts with the first collection action taken against the taxpayer after the date of enactment. Enactment occurred on July 22, 1998, when President Clinton signed the Act.

The IRS Collection Division, of course, is out there taking enforcement action against somebody every day. Thus, starting July 22, 2000, some taxpayers will start losing their right to seek innocent spouse relief for the simple reason that they (or their advisors) waited too long.

Consider the following mildly preposterous example: On July 1st, Scarlett comes to see you. She explains that for many years prior to her divorce from Rhett in 1996 they filed joint returns, and that the IRS assessed large deficiencies after determining that Rhett's plantation business was really a hobby farm. A lien was filed against Scarlett on August 2, 1998, but she talked Revenue Officer Sherman into posting her account "currently not collectible." The IRS isn't doing anything to Scarlett at present, but she wants to resolve this once and for all because she is looking for venture capital to finance an IPO for her new website, called "Kissmygrits.com," figuring to be the next internet millionaire. You put the file aside, planning to get back to it after taking care of all the 1999 1040s you extended to August 15th.

On August 20th, you pull out the file, and after ten minutes reviewing the facts you realize that Scarlett has a great innocent spouse case -- being divorced, she can merely elect to apportion the deficiencies, with said apportionment attributing the whole liability to Rhett. You file a claim for her on this basis, and tell her how lucky she was to have retained you. The IRS, however, denies relief because Scarlett is outside the statutory requirement of filing her claim within two years of the first collection action against her occurring after the date of enactment. Ouch! Please think carefully about the cases now in your office. Could any of them have innocent spouse claims? Will the two year rule prevent relief if action is not taken soon?⁴

Equitable relief

The new innocent spouse rules focus mainly on tax "deficiencies," as opposed to balances shown as due on joint returns but simply never paid. However, one portion of the new rules offers at least the hope of some relief for any balance due with respect to a joint return, even when relief would not be otherwise available. Specifically, new §6015(f) permits the IRS to waive "any unpaid tax or deficiency (or any portion of either)," if in light of all the facts and circumstances "it is inequitable to hold the individual liable."⁵

The IRS was directed to adopt implementing rules, which it did on January 31, 2000, when it issued Rev. Proc. 2000-15. The Rev. Proc. contains two items which warrant close review. First, it presents a list of "threshold conditions" which must be satisfied by all claims for equitable relief, and the second is a list of conditions "under which relief under §6015(f)will ordinarily be granted." The threshold conditions are found in §4.01, and are as follows:

• A joint return was filed.
  
  
• Relief is not available under §6015(b) or §6015(c).
  
  
• The requesting spouse applies for relief no later than two years after the date of the first collection action against her after July 22, 1998.⁶
  
  
• The liability remains unpaid (except that a refund will be considered for payments made after July 22, 1998, and before April 15, 1999).
  
  
• No assets were transferred between the spouses as part of a fraudulent scheme.
  
  
• No disqualified assets were transferred to the requesting spouse by the nonrequesting spouse.
  
  
• The requesting spouse did not file the return in question with fraudulent intent.

Even if these threshold conditions are met, of course, it must still be shown that holding the requesting spouse liable would be "inequitable."

What the Service thinks is "inequitable" can be better understood by considering the kind of case in which Rev. Proc. 2000-15 suggests relief would ordinarily be granted. Such a case would include the following facts:

• The spouses are no longer married (i.e. due to divorce or death), or have been separated for 12 months.
  
  
• When the requesting spouse signed the return in question she did not know and had no reason to know that the tax would not be paid.
  
  
• The requesting spouse would suffer economic hardship if relief is not granted.

If these conditions are met, relief will be granted to the extent that the tax relates to items attributable to the nonrequesting spouse. However, a spouse might still qualify for relief even if the facts are not on all fours with those listed above. Rev. Proc. 2000-15 states that the following factors would influence the decision:

• Marital status. As suggested by the Service's example, a spouse who is divorced or separated will find it easier to obtain equitable relief than one who is still married to and living with the spouse with whom the joint return was filed. Furthermore, spousal abuse is also considered. (Abuse amounting to duress in signing the return can be used to overcome the joint filing election by showing that the election was not freely and voluntarily made in the first place.)
  
  
• No knowledge or reason to know. Though not a "threshold" condition, a spouse's claim for equitable relief is advanced if she can show that she did not know and had no reason to know that the tax would not be paid, or that the return contained errors giving rise to the deficiency at issue, and that such errors were attributable solely to the nonrequesting spouse.
  
  
• Spouse's legal obligation. The Service's position is that a claim for equitable relief is bolstered if it can be shown that the payment of the taxes was the legal obligation of the other spouse pursuant to a divorce decree. In the past, even where one spouse agrees to pay the joint taxes for years prior to the divorce, this was in no sense binding on the Service, and collection of the joint tax debt could be sought from either spouse. Thus, making this as a factor in determining the appropriateness of equitable relief will help many former wives whose ex-husbands have failed to pay pre-divorce income taxes which they were required to pay under the terms of their divorce decrees.⁷
  
  
• Economic hardship. As suggested by the fact pattern in which the IRS has announced that relief will ordinarily be granted, a showing of economic hardship is an important factor. The standards to be used in determining whether the payment of the taxes would cause an economic hardship are the same as those used to determine whether a levy should be withdrawn as set forth in Treas. Regs. §301.6343-1(b)(4). The question is whether enforcement would render the taxpayer "unable to pay his or her reasonable basic living expenses."⁸

Conversely, the absence of the above-listed conditions would weigh against the granting of equitable relief. In addition, Rev. Proc. 2000-15 states that certain other factors would make it more difficult to obtain relief. These include the failure to comply with the requesting spouse's filing or tax payment obligations for years after the year or years for which relief is being sought.

Conclusion

The new innocent spouse rules are a vast improvement over the situation prior to the enactment of the IRS Restructuring and Reform Act of 1998. The IRS, however, has taken every opportunity to interpret the new rules as narrowly as possible. This is especially true of the "equitable" relief provisions of §6015(f), which Congress meant to cover cases which didn't fit the other two forms of innocent spouse protection. In the face of this administrative reluctance to allow relief if there is any conceivable way to avoid it, the successful and timely assertion of an innocent spouse claim requires creativity, diligence, and a complete understanding of the Code and the IRS's implementing pronouncements.⁹

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