Who is Entitled to Innocent Spouse Relief?
Spouses who choose to file their tax returns jointly depend on one another to truthfully report their income and comply with the tax law. When a husband or wife falls short on that obligation, their spouse may find themselves facing IRS collections. The question for many of these spouses is whether they are entitled to innocent spouse relief.
Self-Described “Homemaker” Seeks Innocent Spouse Relief
Donna and Scott Sutherland have been married since 1990. Scott owns and operates a business installing and maintaining draft beer systems in restaurants and sports venues. He has approximately 10 employees. In 2003 and 2004, Scott withheld payroll taxes from his employees’ paychecks and deposited them into the business’s bank account, rather than turning them over to the IRS. Scott and Donna used the money in that account for personal expenses, including vacation expenses.
After an audit, the IRS considered criminal charges against both Donna and Scott. Ultimately, Scott was indicted in 2010 for willfully failing to deposit his employees’ payroll taxes. He entered a plea agreement and in 2011 was sentenced to home confinement, probation, and $254,351 in restitution. He was also required to submit delinquent income tax returns for several years, including 2005 and 2006, which had $41,000 in outstanding tax liability.
Donna signed the 2005 and 2006 tax returns in the courthouse cafeteria one hour before her husband was sentenced. At the time, she believed Scott was going to prison. She also testified she believed that all the outstanding taxes -- including those from 2005 and 2006 -- would be included in his monthly installment payments for restitution. Instead, the IRS attempted to collect those unpaid taxes from Donna directly. In response, she applied for innocent spouse relief.
Seven Factors for Innocent Spouse Relief
The Internal Revenue Code offers innocent spouse relief under three different sections. Donna Sutherland’s case, and this blog, focused on equitable relief based on all the facts and circumstances under Section 6015(f). Under this section, the U.S. Tax Court weighs seven factors for innocent spouse relief:
- Marital status
- Economic hardship
- Significant benefit
- Subsequent compliance with Federal tax laws
- Legal obligation to pay the outstanding tax liability
- Knowledge or reason to know that the tax liability would not be paid
- Mental or physical health
The Court considered each factor in turn.
1. Marital Status
There is separate innocent spouse relief for spouses who are separated, divorced, or widowed after the tax return was filed. Donna and Scott were still married, so the factor was neutral.
2. Economic Hardship
Economic hardship shows an innocent spouse will be unable to pay reasonable basic living expenses while satisfying the tax liability. Donna inherited $325,000 from her mother’s passing and had over $400,000 in the bank at the time of trial. Paying $41,000 would not create an economic hardship.
3. Significant Benefit
An innocent spouse should not receive significant benefit from the wrongfully withheld tax payments. If a spouse enjoys a lavish lifestyle it will work against them, but if they gain little or no benefit from the unpaid tax, it will work in their favor. The Sutherlands went on vacations and paid personal expenses from the business account, but the Court didn’t consider that a “lavish lifestyle,” calling the factor neutral.
4. Subsequent Compliance with Federal Tax Laws
When married spouses continue to file joint returns after requesting innocent spouse relief, the factor is neutral. That was what happened for the Sutherlands.
5. Legal Obligation to Pay the Outstanding Tax Liability
If one spouse has a legal obligation to pay the outstanding tax liability under a divorce decree or legally binding agreement, it can be a factor in favor of innocent spouse relief for the other spouse. Donna argued that Scott’s criminal probation required him to make “a good faith effort to pay all delinquent and additional taxes.” But the Court said that good faith effort didn’t relieve Donna from paying her obligation. This factor, too, was neutral.
6. Knowledge or Reason to Know the Tax Liability Would Not be Paid
Innocent spouse relief is favored if the requesting spouse reasonably expected their husband or wife to pay the tax liability themselves. If the would-be innocent spouse had reason to know the non-requesting spouse “would not or could not pay the tax liability at the time or within a reasonable period of time after the filing of the return” it will weigh against the request. Donna knew that tax liabilities from 2005 and 2006 were still unpaid in June 2011. She testified that she thought Scott would defray those liabilities as part of restitution paid monthly over time because it resulted from his business.
However, Scott’s criminal charges were for nonpayment of employment tax, not income tax. Donna also had far more to do with Scott’s business than she let on, which will be addressed below. The Court said “It is unclear why she would have believed that restitution and income tax would be paid together if they ‘had nothing to do with’ one another.” She had reason to know Scott would face financial difficulty, especially when she believed Scott would go to prison at sentencing.
7. Mental or Physical Health
If a requesting spouse “was in poor physical or mental health” when the tax returns were filed or the relief filed, they may be eligible for innocent spouse relief. This depends on the:
- Nature of the condition
- Extent of the condition
- Duration of the condition
- Ongoing economic impact of the illness
Donna said she “was a mess” when she signed the 2005 and 2006 tax returns. Scott was being sentenced on his plea agreement, her mother had died 2 months earlier, and her brother was demanding part of her inheritance. She was stressed. However, Donna didn’t provide any proof that her health condition affected her ability to comply with the tax laws. The Court said:
“She knew that she was jointly liable for the tax; she neglected to pay, not because of stress, but because she hoped Scott would take care of it at some point. This decision was fully within her control.”
Court Says Business Owner’s Wife Wasn’t Just a Homeowner
A request for equitable relief as an innocent spouse depends on all the facts and circumstances, not just the seven factors. The Court said “petitioner did not turn square corners” in requesting innocent spouse relief.
Donna called herself a “homemaker,” claiming that “my husband kept the finances to himself.” However, the Court said this was “untrue or misleading at best.” Donna was deeply involved in Scott’s business. She may not have been on the company payroll, but she was managing most of the financial aspects of the business including the bookkeeping, billing customers, depositing checks, and preparing W-2s for the company’s employees. The Court said this meant that the “‘reason to know’ factor cuts decisively against” her and her request for equitable relief as an innocent spouse.
The Sutherland case shows how important it is for spouses to deal truthfully with one another and the IRS. If one spouse fails to make payments, the other may be forced to resort to equitable relief to keep from paying more than his or her fair share.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years of experience. If you have questions regarding international spouses’ obligations regarding FBAR requirements or penalties, contact Joe Viola to schedule a consultation.