Innocent spouse relief can allow a taxpayer to avoid joint liability for taxes that arose during the marriage.
There is an exception for the would-be innocent spouse if they had actual knowledge of the item that resulted in the tax.
The U.S. Tax Court addressed this limitation in McDonald v. Commissioner, T.C. Summary Opinion 2016-79, making it possible for taxpayers to qualify for relief even if they have “actual knowledge.”
The Facts & Procedural History
The taxpayers were divorced. The IRS audited their income tax returns and, among other things, proposed a tax adjustment related to rental real estate that the taxpayers owned.
The real estate was located out of state, the taxpayers had local property managers who managed the properties, and the (ex)husband oversaw the rental real estate and kept the books for the real estate. The real estate produced tax losses in excess of $25,000 a year and the taxpayers deducted these amounts each year. The IRS adjusted the losses to $25,000 a year pursuant to the passive activity loss rules.
The (ex)wife requested innocent spouse relief. The IRS concluded that she was entitled to relief. The issue for the court was whether the (ex)wife should be granted innocent spouse relief despite the (ex)husband’s objection.
Innocent Spouse Relief
There are three types of innocent spouse relief. The one at issue, in this case, applies if the taxpayers are divorced.
As mentioned above, there is an exception that can prevent a divorced spouse from qualifying for relief. This exception says that the taxpayer will not qualify for relief if the IRS demonstrates that the would-be innocent spouse had actual knowledge, at the time she signed the return, of any item giving rise to a deficiency or a portion thereof, which is attributable to the other spouse.
This exception has traditionally been applied to cases where the innocent spouse was not aware of an item of income that was not reported on the tax returns. The exception is easier to apply in these cases, as the income is not reflected on the tax returns that the innocent spouse signed. So it is plausible that the innocent spouse may not have been aware of the income that was omitted.
In the McDonald case, the tax losses were reported on the tax returns that the innocent spouse signed. The evidence also showed that the innocent spouse knew of the real estate, the losses, and she even believed that her CPA had told her that she satisfied the tax rules that would allow the losses. It would seem that this is sufficient to establish that she had actual knowledge of the rental losses.
The court concluded that she did not have actual knowledge of the rental losses. The court noted that this exception, by its very terms, puts the burden on the IRS to make the showing. In this case, the IRS agreed that the (ex)wife qualified for innocent spouse relief. The (ex)husband was the only party that objected to granting innocent spouse relief. The law does not address this scenario, so the court applied the exception using a more liberal standard for determining “actual knowledge.”
If the court was correct in applying this standard, the takeaway is that a divorced taxpayer may qualify for innocent spouse relief, even if it is clear that they do not satisfy the exception, as long as they have a sympathetic IRS employee who is assigned to work the case. So it seems that the would-be innocent spouse should err on the side of requesting relief with the hope that they happen to draw an IRS employee who will not contest the issue, rather than not requesting relief.