Who Pays When A Spouse Hides Income?

The IRS wants to clarify joint-return liability

A divorce is bad enough without the surprise of finding you owe taxes on income your estranged spouse didn't report to the Internal Revenue Service. Congress recognized that problem in 1998 when it passed the IRS Restructuring and Reform Act. The law made it easier for so-called innocent spouses who signed joint returns to get relief from liability for taxes on income their husbands or wives hid from them and Uncle Sam.

But, like many parts of the federal tax code, the 1998 law--though well intentioned--proved confusing. So now the IRS is proposing regulations to clarify certain parts of the law. Under the new rules, which will get a public hearing on May 30 in Washington, the IRS will protect the privacy of spouses involved in bitter divorce cases, where there might be a fear of reprisal from a vengeful husband or wife. When an innocent-spouse claim is filed, both husband and wife are contacted. But the IRS promises to omit from documents any information that could identify either spouse's location.

HIS AND HERS LIABILITY. Another proposed modification involves allocating liability between spouses. Take, for example, a couple in which the wife underreported income from her consulting business, and the husband neglected to report capital gains from his investments. Each was unaware of the other's hidden income. The 1998 law provided only for proportional allocation, so if the wife's underreported income was $20,000 and the husband's $30,000, then she would be liable for 40% of the tax debt and he for 60%.

The proposed regulations would allow the IRS to take into account that the husband's income is subject to the lower capital gains rate, whereas the wife's is taxed at the regular income tax rate. So in fact, the husband's share of the total tax liability would be smaller than under the current method.

Finally, the IRS is taking steps to curb the flurry of preemptive innocent-spouse petitions filed by divorce attorneys in the wake of the 1998 law. The agency will not consider any requests for relief filed before a notification of an audit or outstanding liability has been issued. "There is no requirement for a preemptive filing, and from the point of view of a tax practitioner, it would be foolish because you're alerting the IRS that there is an issue," said Robert Goldstein, a CPA and partner with Leipziger & Breskin in New York.

The IRS proposal also provides examples for provisions in the 1998 law that weren't clear. For instance, it clarifies that a couple must be legally separated or divorced, or estranged for at least a year, before they can request an allocation of tax liability. In such a case, the spouse seeking relief admits to knowing of some of the underreported income, so he or she would be held liable only for the taxes owed on that amount.

PROVING A NEGATIVE. Take a situation in which a husband and wife are legally separated, and the IRS determines that a joint filing had underreported income from the husband's plumbing business by $10,000. The wife, while claiming not to know the exact amount of the plumbing income, admits she knew her husband received at least $6,000 more than was reported. Under the law, the wife would be jointly liable for the tax on the $6,000 she says she knew about, but could request that she be absolved of paying any share on the remaining $4,000. Although the IRS doesn't spell out the ways by which you can prove you have no knowledge of the underreported income, it often considers bank statements, deposit slips, or minutes of business meetings.

Regardless of the wider grounds for relief, spouses should take a proactive approach if they suspect a tax problem (table). "If you're signing a joint return and you're not paying attention, then you run the risk of being held liable," says Raoul Felder, a New York divorce lawyer.

"It's benign neglect if you look the other way." In other words, do your best to make sure you're not an ignorant spouse.

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