Jan 22, 2009

Innocent Spouse Relief- Is that for me??

Unfortunately, marriage sometimes ends in divorce. In fact, in the United States, it occurs about 40-50% of the time. To make matters worse, sometimes tax problems occur after a divorce or separation is finalized. Many times, emotional divorce situations fail to consider the post-divorce tax implications. However, all is not lost, for there is relief in what is referred to as "innocent spouse" relief.

Here is an example of a typical fact situation of a tax problem that arises in marriage but surfaces after divorce:

In year 2001-2003, John and Jane Doe file a joint tax return. John is self-employed and Jane stays at home with their two children. John reports income of $100,000 in each year and pays the associated tax with the timely filed return. Jane, who does not handle the finances or the taxes of the home, signs the tax return that John brings home from their accountant on April 14th of each year. On June 30th, 2004, John and Jane get a divorce. On September 30th, John and Jane receive a letter from the IRS that states that they owe an additional $10,000 in tax for the errors made on the 2001-2003 tax years for not reporting $12,000 in income in each year.

The income that was not reported relates to John’s business in which he failed to report all income on their tax return. The audit ensued and their joint liability was assessed. John receives the notice and does nothing about it. Jane is unaware of the return audit, the assessment, or any ensuing collection on the liability. The $10,000 in tax liability by June, 2005, grows, with penalties and interest, to $22,000.

Jane has returned to work in 2004 and files a return for 2004 and the IRS takes her $3,000 refund due to the unpaid joint liability. Also, the IRS is now sending her threatening notices to levy her wages and bank accounts for the unpaid balance of $19,000.
Jane wonders if there is anything she can do about this tax problem.
Jane is in despair, but what she may or may not know is that she may qualify for relief as an “innocent spouse.”

There are three types of Innocent Spouse relief:

Traditional innocent relief- your spouse did something wrong on your return and you are potential not liable
Separation of Liability- the understatement of tax allocated to you is generally the amount for which you are responsible
Equitable Relief- taking into account all the facts and circumstances, it would be unfair to hold you liable for the understatement or underpayment of tax

The requirements are generally the following:

1. Must file the form 8857 no later than 2 years after collection starts
2. Must file a joint return
3. Understatement of return due to error by the non-requesting spouse
4. At the time of the signing the return, did not know of understatement (and prove this)
5. It is inequitable to hold the requesting person who did not know of the error (understatement) liable for the additional tax

What are your chances of obtaining the relief (assuming you meet the pre-requisites above)- here are the factors for and against relief:

Factors for Relief
1. Your marital status is divorced or separated (in fact, for Separation of Liability, it is required for at least the past 12 months)
2. Requesting spouse will suffer a hardship due to the error
3. The requesting spouse has suffered abuse
4. In a divorce decree or separate legal arrangement, the non-requesting spouse is obligated to pay the liability (it is helpful if the decree states why they are liable- i.e. it was their error that was not known to the requesting spouse)

Factors Against Relief
1. The understatement is attributable to an error made by the requesting spouse
2. The requesting spouse had knowledge or a reason to know of the omission or error
3. The requesting spouse received significant benefit from the income that was understated
4. In a divorce decree or separate legal arrangement, the requesting spouse is obligated to pay the liability

Clearly, Jane has a good case for relief. She should file a Form 8857 with the IRS within the 2 year window from when the IRS starts collecting (absent the two year window, she will have an uphill battle to fight to have the IRS consider the innocent spouse relief). Jane will have to build her case knowing that the IRS will ask her former spouse about what she is allegating against him (he will be asked for his side of the story!). The biggest factor for Jane is whether she knew of the understatement or had benefit from it. Jane should center on this argument.

Divorce is painful. Taxes from a past relationship can make it more painful. Exploring your options for innocent spouse may be your best option to finally get that part of your life behind you.

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