Allocations After Innocent Spouse Relief Granted

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When a married couple files a joint tax return, both spouses are jointly and severally liable for the full amount of tax owed. This means that the IRS can collect the entire tax liability from either spouse, regardless of who earned the income or claimed the deductions.

However, in certain situations, a spouse may be granted innocent spouse relief. This results in the so-called innocent spouse not being responsible for their partner’s unpaid taxes.

So what happens when the IRS has already collected on the debt by collecting from jointly owned property? We have previously explained that the innocent spouse may be entitled to a refund in these situations. But how exactly do you calculate the amount of the refund? The recent O’Nan v. Commissioner, T.C. Memo. 2024-57 and T.C. Memo. 2023-117 case provides an opportunity to consider this topic. The court explains how to allocate the amounts the IRS collected before innocent spouse relief is granted.

Facts & Procedural History

The taxpayer-wife and her husband purchased a family home in Ohio in May 2012. The deed conveyed legal title to them as joint tenants with the right of survivorship.

The home was encumbered by two mortgages: a primary mortgage held by Wells Fargo Bank and a secondary mortgage held by First Bexley Bank. While both spouses signed the mortgage deeds, only the husband signed the promissory note for the Wells Fargo mortgage.

The couple filed joint income tax returns for 2012 and 2013 and did not pay the reported tax liabilities. After the husband died in November 2014, the taxpayer-wife owned 100% of the home and she sold the home. The IRS had a tax lien on the home. From the sale proceeds, the IRS collected $123,200 to satisfy the outstanding tax liabilities, plus interest and penalties.

The taxpayer-wife requested innocent spouse relief, which the IRS granted. The IRS denied her claim for a refund of the $123,200 collected from the home sale.

Innocent Spouse Relief & Joint and Several Liability

When a married couple files a joint income tax return, they are generally held jointly and severally liable for the tax owed. This means that each spouse is individually responsible for the entire tax liability, regardless of who earned the income or claimed the deductions.

The IRS can pursue collection actions against either spouse to satisfy the debt.

However, the tax code provides relief for “innocent spouses” who meet certain criteria. To qualify for innocent spouse relief, the requesting spouse must file Form 8857 (Request for Innocent Spouse Relief) with the IRS. The IRS will then review the request and make a determination based on the facts and circumstances of the case. If granted innocent spouse relief, a taxpayer is no longer held liable for their partner’s or ex-partner’s tax debts.

Types of Innocent Spouse Relief

Congress provided for more than one type of innocent spouse relief. There are three types of innocent spouse relief, with each having its own qualification criteria:

  1. Traditional innocent spouse relief (Section 6015(b)): This applies when there is an understatement of tax on a joint return due to erroneous items (such as unreported income or incorrect deductions) attributable to one spouse. The innocent spouse must prove that they didn’t know and had no reason to know about the understatement when signing the joint return and that holding them liable would be unfair.
  2. Separation of liability relief (Section 6015(c)): This applies when the spouses are divorced, legally separated, or have not lived together for twelve months before the relief is requested. The innocent spouse can elect to allocate the understatement of tax between themselves and their former spouse, limiting their liability to their portion of the understatement.
  3. Equitable relief (Section 6015(f)): This is a catch-all provision that applies when the other two types of relief are not available. The IRS considers various factors to determine if holding the spouse liable would be inequitable, such as economic hardship, knowledge of the understatement, and whether the innocent spouse received a significant benefit from the unpaid tax.

The first two types of relief require there be an understatement of tax, i.e., an IRS audit adjustment or something else that increases the amount of tax due. That isn’t the situation in the present case which involved a correct liability that simply wasn’t paid. This is where the third type of relief, equitable relief, comes in.

For all three types of relief, it’s important to note that innocent spouse relief only applies to joint tax returns. If a couple files separate returns, each spouse is only responsible for the accuracy of their own return and the payment of their own tax liability.

Allocations After Innocent Spouse Relief Granted

That brings us to the current court case. This case involves a refund when the IRS has collected on a tax debt by collecting from jointly owned property, and one spouse is subsequently granted innocent spouse relief. But this leaves the question of how to allocate the refund between the spouses in this situation.

The IRS’s Proposed Allocation

For the allocation of the sale proceeds, the IRS argued that because the federal tax lien attached to both the husband’s and wife’s interests in the jointly owned property, the wife only had a right to the portion of the net proceeds that remained after the full value of the federal tax lien and other encumbrances were deducted.

In other words, the IRS claimed that none of the $123,200 it collected from the sale proceeds came from the sale of the property and the lien was filed prior to the spouse being granted innocent spouse relief. Therefore, according to the IRS, the wife was not entitled to a refund.

The IRS’s math looks like this:

Husband’s Share Wife’s Share
$447,500 (50% of sale proceeds) $447,500 (50% of sale proceeds)
– $7,145 (50% of closing costs) – $7,145 (50% of closing costs)
– $423,020 (Wells Fargo mortgage) – $257,955 (First Bexley mortgage)
– $17,335 (Remaining for First Bexley and IRS) – $123,200 (IRS collection)
= $59,200 (Proceeds paid to wife)

With this, the wife would not be entitled to any refund.

The Tax Court’s Allocation

The tax court did not agree with the IRS’s position. The court pointed out that while the IRS was correct that the tax lien initially attached to both spouses’ interests in the property, the grant of innocent spouse relief under Section 6015(f) effectively limited the wife’s liability to $3,340. Consequently, the IRS was only entitled to collect $3,340 (plus interest) from the wife’s share of the proceeds.

The court’s analysis focused on the allocation of the sale proceeds between the spouses’ interests and the priority of the encumbrances on the property. By determining that the husband’s share of the proceeds was insufficient to cover the entire amount collected by the IRS, the court concluded that a portion of the funds must have come from the wife’s share, despite her being granted innocent spouse relief.

Here are the steps the court applied in reaching this determination:

  1. Recalculation of tax liability: The court found that when a spouse is granted relief under Section 6015(f), their tax liability should be recalculated as if they had filed a separate return. This is a crucial step because it establishes the innocent spouse’s revised tax liability, which is separate from their partner’s or ex-partner’s liability.
  2. Extent of the IRS’s lien: The court determined that the IRS’s lien only encumbered the innocent spouse’s interest in the jointly owned property to the extent of her revised tax liability. This means that after the innocent spouse’s tax liability is recalculated, the IRS can only claim a portion of the innocent spouse’s share of the property proceeds equal to their revised liability.
  3. Allocation of sale proceeds: The court analyzed the allocation of the sale proceeds between the spouses’ interests in the property. In this case, the court found that the husband’s share of the proceeds was insufficient to cover the entire amount collected by the IRS, due to the outstanding mortgage balances. As a result, a portion of the funds collected by the IRS must have come from the taxpayer-wife’s share of the proceeds.

The tax court’s math looks like this:

Husband’s Share Wife’s Share
$447,500 (50% of sale proceeds) $447,500 (50% of sale proceeds)
– $7,145 (50% of closing costs) – $7,145 (50% of closing costs)
– $423,020 (Wells Fargo mortgage) – $0 (Not personally obligated)
– $17,335 (Remaining for First Bexley and IRS) – $257,955 (First Bexley mortgage)
– $123,200 (IRS collection)
+ $119,860 (Refund due to innocent spouse relief)
= $59,200 (Proceeds paid to wife)

Total tax liability: $114,791
Husband’s liability: $111,451
Wife’s liability after innocent spouse relief: $3,340

As this shows, since the taxpayer-wife had been granted innocent spouse relief under Section 6015(f), the court held that the IRS’s lien only encumbered her interest in the home to the extent of her remaining tax liability after the relief was granted. Consequently, the court determined that she was entitled to a refund of the amount collected by the IRS that exceeded her revised tax liability.

Community Property States and Innocent Spouse Relief

In community property states like Texas, the analysis for determining the refund amount owed to an innocent spouse after they are granted relief under Section 6015(f) would follow similar principles to the common law state scenario, even though the rules are different for community property states.

Regardless of whether it is a community property or common law state, when one spouse is granted innocent spouse relief, their remaining tax liability should be recalculated as if they had filed a separate return. The IRS’s lien against the innocent spouse’s share of any jointly-owned property is limited to only that recalculated, separate tax liability amount after relief is granted. Any amounts collected by the IRS from the innocent spouse’s share of assets exceeding that remaining liability amount must be refunded back to the innocent spouse.

In community property states like Texas, there could be a difference, however. In community property states, the mortgage may be a community debt that belongs equally to both spouses. In community property states like Texas, both the tax liability from the joint return and the mortgages on the jointly-owned home would likely be considered community debts belonging equally to both spouses.

The overall allocation would then be:

Husband’s Share Wife’s Share
Husband’s Tax Debt: $57,395.50 Wife’s Recalc. Tax Debt: $3,340
Wells Fargo Mortgage: $211,510 Wells Fargo Mortgage: $211,510
First Bexley Mortgage: $128,977.50 First Bexley Mortgage: $128,977.50
IRS Collection: $123,200
Wife’s Refund: $119,860

In this situation, after allocating 50% of all community debts to each spouse:

  • The IRS collected $123,200 from the wife’s share of the home equity
  • But her total recalculated debts were only $344,827.50 ($3,340 tax + $341,487.50 for the mortgages)
  • So she would still be entitled to a $119,860 refund from the overcollection

The refund amount remains the same, but splitting the mortgage debts 50/50 first, per community property principles, does impact the overall allocation.

So in both common law and community property states, when granted innocent spouse relief under Section 6015(f), the innocent spouse would be entitled to a refund of $119,860 from the IRS for the amounts overcollected based on the facts presented.

Different Numbers: Higher Tax Liability and Lower Mortgage

The analysis can still be problematic for taxpayers. For example, if the mortgage balances were lower and the tax liability higher, then the allocation could result in the wife not being entitled to a refund.

Assume the following:

  • The total sale proceeds from the home remain at $1,000,000.
  • The primary mortgage held by Wells Fargo is reduced to $50,000, and only the husband signed the promissory note.
  • The secondary mortgage held by First Bexley Bank remains at $100,000.
  • The closing costs are still $14,290.
  • The joint tax liability is higher, say $250,000, with the husband responsible for $246,660 and the wife, after innocent spouse relief, responsible for $3,340.

The IRS would allocate the sale proceeds as follows, considering the lower mortgage and higher tax liability:

Husband’s Share Wife’s Share
$500,000 (50% of sale proceeds) $500,000 $500,000
Less: $7,145 (50% of closing costs) – $7,145 – $7,145
Less: $25,000 (Wells Fargo mortgage) – $25,000 – $0 (Not personally obligated)
Less: $50,000 (First Bexley mortgage) – $50,000 – $50,000
Less: $250,000 (IRS collection) – $250,000 – $0
$167,855 $442,855

If the IRS (or court) recalculates the wife’s tax liability after granting innocent spouse relief and limits her liability to $3,340, the calculation of the refund would be as follows:

Given the lower mortgage and higher tax liability, the IRS collected $250,000 from the sale proceeds:

  • Husband’s liability: $246,660
  • Wife’s liability after innocent spouse relief: $3,340
  • Total collected by IRS: $250,000

With this example, the wife would not be entitled to a refund since the IRS collected all but the $3,340 that the wife owed from her husband’s share.

The Takeaway

This case highlights the complex interplay between innocent spouse relief and the IRS’s collection actions on jointly owned property. When one spouse is granted relief, it may have significant implications for the allocation of amounts already collected by the IRS. Taxpayers facing similar situations should consider whether they are entitled to a refund of funds incorrectly collected by the IRS.

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