Help - the IRS is after me! I’m an employee - my taxes are taken out of my pay - my wife is self-employed - the government says we owe money due to some issue with her business - we field a joint tax return - am I on the hook? In most situations yes - however the IRS has a program it refers to as Innocent Spouse. This program may provide you with relief.
In our last post we discussed the basics of tax returns and tax liability for married couples. Every individual (with sufficient taxable income) has a tax filing obligation. This is an individual obligation - even for married taxpayers. For taxpayers electing to participate in the filing of a joint tax return the obligation for unpaid tax is “joint and several”. This means collection of the entire tax can be attempted from each spouse - up to the entire amount of unpaid tax.
For this discussion I’m assuming that the taxpayers do not live in a “community property” state.
So if I did participate in the filing of a joint tax return am I stuck with this joint and several liability. Well… not always.
Let’s discuss an example - using Larry and Martha from our previous post.
Larry is an employee and Martha is self-employed. They married in 2021. For 2020 each of them filed tax returns as Single. Larry had an overpayment of tax reflected on his tax return while Martha had a balance due. Martha did not pay the balance due that was reflected on her tax return. As discussed in the last post Martha has an individual obligation for the tax debt - Larry is not responsible for the debt.
Let’s assume their personal earnings / tax situation is the same for 2021 - they do choose to elect to file as Married Filing Joint. Their income and deductions are combined and there will be a tax amount determined. Larry’s wage withholding will be used to offset this tax liability. Assuming the withholding is less than the tax there will be no refund. There now exists joint and several liability for the unpaid tax - even though on a separate basis Larry has paid in enough to cover his portion of the liability. This means the IRS will attempt to collect 100% of the tax from both Larry and Martha.
I’ve just told you that Larry is on the hook for 100% of the tax debt. Is all lost for Larry? Well not necessarily - Larry could request that he be considered an “Innocent Spouse” (IS). If the IRS were to allow for Larry to claim relief as an Innocent Spouse he would be granted some relief - which could be either an apportionment of the tax debt between he and Martha, or even total relief from the debt.
This relief is far from automatic. Similar to a request for an Offer In Compromise the relief has to be requested from the IRS and certain requirements must be met. The IRS has a great deal of discretion in granting Innocent Spouse relief.
The fact that Larry could demonstrate that his withholding was sufficient to cover the tax associated with his income does not automatically entitle him to relief. The IRS takes the view that he and Martha could have each filed their own tax returns. Instead they chose to participate in a joint filing - which gives rise to the joint and several tax obligation.
There are three types of IS relief available:
- Innocent Spouse Relief
- Separation of Liability Relief
- Equitable Relief
Each of these types has its own requirements and relief provisions.
Innocent Spouse Relief
- The tax debt arose due to an “erroneous item” - i.e. an understatement of income and/or overstatement of deductions - this relief is not available for debts reflected on a tax return that are not paid with the filing of the tax return - i.e. an underpayment
- The spouse did not know or have reason to know of the erroneous item
- The IRS determines that to hold the spouse responsible for the debt would be “inequitable”
- Relief must be requested within two years of when collection activity begins
- Relief consists of an allocation of the liability
- The allocated liability is compared to payments made by the spouse - the result will be either an amount due or an overpayment - in an overpayment situation a refund may be available if IS relief is granted within three years of the return filing
Separation of Liability
- Spouse must be divorced or legally separated for at least twelve months
- The tax debt arose due to an erroneous item
- Spouse had no knowledge of the erroneous item
- Relief must be requested within two years of when collection activity begins
- Relief consists of treating the spouse as if they filed separately
- No refunds available
Equitable Relief
- All “facts and circumstances” are considered
- The tax debt arose either due to an erroneous item or an underpayment of tax - i.e. return was filed with a tax due amount but no payment was made
- Relief must be requested before expiration of the Collection Statute of Limitations - generally 10 years from the date the tax return was filed
- Relief consists of an allocation of the liability
- The allocated liability is compared to payments made by the spouse - the result will be either an amount due or an overpayment - if an overpayment a refund may be available if IS relief is granted within three years of the return filing
The IRS considers a number of factors in evaluating any claim for Innocent Spouse relief. In connection with the Equitable Relief program the IRS published a list of factors that it will consider:
- Marital status - are the spouses no longer married when relief is sought
- Economic hardship - would holding the spouse responsible for the tax cause the spouse to be unable to pay reasonable basic living expenses
- Knowledge or reason to know - at the time the joint return was filed did the spouse know or have a reason to know of the understatement or that the non requesting spouse would not or could not pay the liability reflected on the tax return - in situations involving abuse or financial control by the non-injured spouse if the spouse was not able to challenge the treatment of any items on the joint return for fear of retaliation this factor may be considered
- Non-requesting spouse’s legal obligation - where the non-injured spouse agreed to assume liability for the tax - typically seen in the context of divorce agreements
- Significant benefit - did the spouse benefit from the underpayment or nonpayment of tax - i.e. the spouse enjoyed the benefits of a lavish lifestyle - however note that the rule relating to abuse above may be considered
- Compliance with income tax laws - did the spouse comply with the tax rules in years after the year(s) at issue
- Physical or mental health - whether the requesting spouse was in poor physical or mental health - at the time the return was filed or when requesting relief
These factors may also be relevant in evaluating claims under the Innocent Spouse and Separation of Liability provisions.
In considering economic hardship the IRS uses the concept of “Reasonable Collection Potential” - RCP. This is the same information used by the IRS in evaluating other debt resolution options - i.e. Offer In Compromise, Installment Agreement, etc. As discussed in a previous post RCP is an approximation of the amount the IRS could collect through forced collection activities (i.e. lien and levies). It considers net equity in assets, future gross income, and allowable living expenses.
Another term arises when discussing taxes and spouses - Injured Spouse. This concept is the opposite of Innocent Spouse. In this situation an overpayment reflected on a joint tax return is seized by the IRS to cover the individual liability of one spouse. In these situations a portion of the refund can be refunded to the non-liable spouse.
A joint tax return can be elected after filing as Married Filing Separately but once a joint return is filed there is no option to file separately. So if in doubt file separately.
Once a joint return is filed relief is required to be requested under these Innocent Spouse provisions. As with most other debt relief alternatives relief is not automatic but may prove beneficial in the right circumstances.
In our next blog post we’ll discuss IRS Notices.
As always feel free to contact us if you need assistance - click Contact Us
Link to Outline Slides: Outline - Innocent Spouse
Link to Video: Video - Innocent Spouse
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