Married couples who file joint tax returns are both liable for any deficiencies or underpayments. But if one spouse qualifies as an “innocent spouse,” they can be relieved of the tax burden.
An important question arises – if an innocent spouse previously paid the joint tax debt, are they entitled to a full refund?
A recent case from the Ninth Circuit Court of Appeals, Orlock v. Commissioner, 755 F.3d 915 (9th Cir. 2014), examined the thorny issue of recouping payments after separation of liability.
Facts & Procedural History
This case involves a wife who was granted innocent spouse relief by the IRS for taxes owed jointly with her husband. Prior to approval, the wife had paid a portion of the tax debt using both separate property and community property funds.
The wife filed a claim requesting refunds for the full amount paid. The IRS refunded payments from separate property but denied refunds for the community property funds. On appeal, the Ninth Circuit affirmed the IRS’s position.
Joint Tax Liability and Innocent Spouse Relief
Under the standard joint return filing status, married couples assume joint and several liability for any tax deficiencies or underpayments. The IRS can collect the full amount due from either spouse, regardless of who earned the income or made errors.
However, the innocent spouse provision of Section 6015 offers relief by separating liability. To qualify, the innocent spouse must establish:
- They had no knowledge of the understatement when signing the return. Mere unawareness is insufficient – they must show lack of both knowledge and reason to know.
- They did not financially benefit beyond normal support from the understatement. Significant or lavish benefits could preclude relief.
- It would be unfair to hold them liable, often due to abuse, intimidation, or coercion by the other spouse. Physical violence need not be proven.
In addition to regular relief under Section 6015(b), equitable relief is available in limited circumstances if the other requirements are not satisfied.
Obtaining innocent spouse status relieves the qualifying spouse from responsibility for the tax debt. The IRS can only seek payment from the non-innocent spouse based on their separate income and assets.
About Community vs. Separate Property
State law definitions of separate and community property play a key role in determining innocent spouse refund rights.
In community property states like California and Texas, most assets acquired during a marriage are deemed community property, jointly owned by both spouses. This includes earnings, property bought with those earnings, and appreciation of those assets.
Separate property is excluded from community assets. This includes:
- Assets owned before the marriage
- Inheritances and gifts received individually
- Damages from personal injury lawsuits
- Assets acquired after legal separation
Community property is liable for debts incurred by either spouse. But separate property cannot be seized to pay the other spouse’s debts.
Classifying the source of tax payments as community or separate funds provides the basis for IRS refund determinations after granting innocent spouse relief. Understanding state law ownership rules is essential.
Refund Rights After Innocent Spouse Relief
A frequent question is whether an innocent spouse can recover joint tax payments made before receiving relief. The Ninth Circuit in Orlock held that refunds are only required for payments from the innocent spouse’s separate property, defined by state law.
Payments sourced from community property jointly owned with the non-innocent spouse need not be refunded. The logic is that community funds could rightfully be used to satisfy the still-outstanding tax debt attributed to the non-innocent spouse after separation of liability.
The IRS follows this distinction in processing refunds. Innocent spouses must clearly track and document that refund requests derive only from separate property sources. Payments already made from joint community property are generally not recoupable.
Complications can arise in states treating earned income as community property. If joint tax payments came from a joint bank account funded by both spouses’ earnings, refunds may be limited. Careful planning is advisable when requesting relief.
The Ninth Circuit affirmed the IRS’s policy to limit refunds to payments clearly sourced from the innocent spouse’s separate property only. This precedent may constrain refunds in community property states. Consult a tax professional for guidance on maximizing recoveries.
Tips for Taxpayers with Joint Liabilities
For taxpayers filing jointly who face potential deficiencies or disputes, here are some tips to protect your interests:
- Request innocent spouse relief promptly when you become aware of an understatement – don’t delay until after payment.
- Maintain thorough documentation separately showing the source of any payments made toward joint tax debts. Track payments derived from separate property versus community funds.
- Keep separate bank accounts and carefully document the flow of funds between accounts, especially in community property states. Commingling assets can cause headaches.
- If you qualify as an innocent spouse, file for refunds of prior separate property tax payments quickly before statutes of limitations expire.
- Work with an experienced tax professional to understand state laws and navigate documentation. Don’t go it alone.
- Be proactive in requesting relief before the non-compliant spouse incurs more joint liabilities. Act before issues compound.
Exercising caution around joint tax filings and liabilities can prevent difficult situations down the road. Being prepared with documentation also smooths the process if innocent spouse status is needed.
This court case raises procedural challenges for the IRS in tracking sources of tax payments by innocent spouses seeking refunds. The key precedent set is that refunds are only required for payments clearly traced to the innocent spouse’s separate property, not jointly owned community funds. This ruling may significantly limit refunds in community property states. Innocent spouses should promptly request relief and carefully document the source of any prior payments as separate property. Consulting a tax professional is advisable to maximize recoveries.