The IRS has wide discretion in how it administers our tax laws. This discretion is power in its purest sense. This power can be wielded to destroy hard-won reputations, careers, and fortunes and it can even cost individuals their freedom.
These powers can come from ambiguities in our laws. They can come from restrictions in our laws that have no remedy if the IRS violates them. And in other cases, they can come as a direct grant of discretion from Congress.
The innocent spouse relief rules are an example of a direct grant of discretion. Innocent spouse relief is serious business. The rules can allow one spouse to avoid owing or paying taxes. This can come at the expense of the other spouse. It can even result in one spouse getting a tax refund, while the other spouse has to pay tax. Even the bankruptcy rules do not forestall an innocent spouse claim.
Congress provided some guidance as to who qualifies for this relief, but it leaves the details to the IRS. The IRS has exercised this discretion to establish a framework and rules for when relief will be granted. Even with these provisions, individual IRS employees still have wide discretion to grant or deny relief.
The Sutherland v. Commissioner, T.C. Memo. 2021-110 case provides an opportunity to consider the power the IRS and its employees have with respect to this type of tax relief. It shows that the IRS is not limited to just the stated factors for granting or denying innocent spouse releif. Those seeking innocent spouse relief should be cognizant of this as these additional factors can help or hurt one’s request.
Facts & Procedural History
This case presents a very common fact pattern. The husband owned and operated a small business. The wife was a stay-at-home mother and assisted with the paperwork for the husband’s business.
This common fact pattern takes a turn from there. The husband’s business had payroll taxes were withheld from employees, but the funds were not remitted to the IRS. The IRS criminal investigation function worked the case. They determined that the payroll taxes were used for personal expenses, such as vacations.
The wife signed the fraudulent payroll tax returns.
The husband was indicted for the unpaid taxes and entered into a plea agreement. The plea agreement required the taxes be paid back. The wife filed a request for innocent spouse relief. The IRS denied the request and tax litigation ensued.
About Innocent Spouse Relief
If a married couple files a joint tax return, both spouses are jointly and severally liable for any tax reported on or attributable to the tax return.
The IRS can collect the tax owed from one or both spouses under this joint tax liability. The law provides a remedy for innocent spouses in order to remedy injustice in holding both spouses liable for the taxes.
This “innocent spouse relief” can be found in Section 6015 of the tax code. For those in community property states like Texas, Section 66 also comes into play.
What these provisions say is that, generally, there are three types of innocent spouse relief:
- Basic Relief – this remedy is available if a joint tax return was filed, but the item that triggered the tax was due to the other spouse and was not reported on the tax return, unbeknownst to the innocent spouse. There are five factors that have to be satisfied to qualify for this type of relief. This relief has to be requested within two years of the date the IRS attempts to collect the tax.
- Separation Relief – this relief is available for spouses who are separated, divorced, or living apart. It is similar to basic releif, but it does not have all of the five factors that are required for basic relief. This releif also has to be requested wtihin two years of the date the IRS attempts to collect the tax.
- Equitable Relief – this relief is available if the other two types of innocent spouse relief are not available. It applies if it would be inequitable to hold the innocent spouse liable for the tax when taking into account all of the facts and circumstances.
When Innocent Spouse Relief is Granted
If granted, all three of these options can be used to relieve the innocent spouse from liability for the tax deficiency. This means that the innocent spouse can challenge the amount of the tax using these options. These options can be used to adjust the innocent spouse’s tax balance on account with the IRS down.
The IRS usually accomplishes this by splitting the tax between the spouses as if they had filed as married filing separately. The IRS refers to this as apportioning the tax liability. It also “mirrors” the IRS accounts by creating a new IRS account for the year for the spouse who is listed second on the tax return for the year in question. That way both spouses have an open module in the IRS’s computer system, then the module is adjusted to reflect each spouse’s separate liability.
The last option, equitable relief, can also be applied to tax debts. This means that the tax deficiency or balance is not apportioned between the spouses. Instead, the IRS can simply not collect from the innocent spouse.
About Equitable Relief
The tax code does not provide rules for determining whether equitable relief should be granted. The IRS has supplied the rules in the form of Revenue Procedures. Rev. Proc. 2013-34 provides the most recent version of these rules.
Rev. Proc. 2013-34 sets out seven threshold conditions that must be met. Once these are met, the guidance allows for both streamlined relief and regular relief.
Streamlined relief applies the spouses are divorced, the innocent spouse will suffer economic hardship, and the innocent spouse did not know of the tax problem.
If the innocent spouse cannot qualify for streamlined relief, he or she may qualify under regular relief. There are seven factors that are to be considered for regular relief:
- Marital status
- Economic hardship
- Knowledge or reason to know
- Legal obligation
- Significant benefit
- Compliance with income tax laws
- Mental or physical health
There are quite a few court cases that address these factors. The Sutherland case is an example. In Sutherland, the court went through each factor. The court noted that most factors did not favor granting innocent spouse relief.
Additional Factors for Equitable Relief
The court went further. It noted that there were other factors that it also considered:
The revenue procedure notes that the seven factors discussed above are “not intended to comprise an exclusive list” and that “[o]ther factors relevant to a specific claim for relief may also be taken into account.” Rev. Proc. 2013-34, sec. 4.03(2); see sec. 6015(f)(1)(A) (requiring “all the facts and circumstances” to be considered). We conclude that two additional factors weigh against equitable relief.
The factors the court considered were the innocent spouse’s inheritance that was not used to pay the taxes and the innocent spouse’s credibility. The court noted that the inheritance could have been used to pay the tax liability. The court seems to have reasoned that using these funds to pay taxes may have resulted in inequity between the innocent spouse and the non-innocent spouse; it would not have resulted in inequity between the innocent spouse and the IRS.
As for the innocent spouse’s credibility, the court noted what it perceived as discrepancies in her testimony in court versus what she had listed on her innocent spouse paperwork. The court noted that the innocent spouse was the bookkeeper for the husband’s business. Therefore, her statements that she was not aware of the business’s finances or tax issues were not credible.
This case shows that one is not limited to just the seven factors for regular equitable innocent spouse releif. There may be other factors that justify granting innocent spouse releif or denying it. Those submitting requests for innocent spouse relief should not hesitate to raise additional factors when appropriate.
Innocent spouse relief can and should be considered when there is a joint income tax liability. It should be considered even if the spouses are married and not separated. Ideally, it should be considered early in the IRS collection efforts. This can afford the innocent spouse more options and increase the chances that their tax deficiency or balance is adjusted.