Understating Income on Your Tax Return – Are You an Innocent Spouse?

Demystifying Valuation, Economic Damages + Forensic Accounting

When we are providing consulting services relating to a divorce, we are often asked to perform a business valuation and/or make a determination of income of one or both of the spouses for support purposes.   During the course of our work we will review and utilize the joint income tax returns of the parties.  It is not unusual for one of the spouses to inform us that the income or deductions reported on tax returns are not correct, and that the taxable income is significantly understated in an effort to avoid taxes.

In cases such as these, we will perform forensic accounting procedures to determine the actual income of the business and/or parties.  The parties may be concerned that the divorce court judge will report the underpayment of income taxes to the Internal Revenue Service.  There are, in fact, cases when a Judge has recognized a duty and obligation to report the non-payment or underpayment of taxes to the taxing authorities .

Often, the spouse who is alleging the underpayment of taxes will explain that they were not involved in the preparation of the tax returns and simply signed the returns each year.  The husband or wife has usually done some research and will tell us that he or she is an “Innocent Spouse.”   The Innocent Spouse rules will provide relief from liability for tax, interest and penalties under certain circumstances.   We will not offer tax or legal advice as part of our role in the divorce litigation.  However, for informational purposes, here are some of the basics regarding the Innocent Spouse Rule.  (A tax attorney should be consulted for advice.)

There are three types of relief discussed in Internal Revenue Code Section 6015:  1) Innocent Spouse Relief; 2) Separation of Liability and 3) Equitable Relief.  If the taxpayer is divorced, separated or no longer living with the spouse, relief can be requested by separating the liability for an understatement of tax between the parties.  The IRS may also grant “Equitable Relief” if it would be unfair to hold the taxpayer liable for the tax that should be paid only by one spouse.  Each type of relief has different requirements. 

The spouse may be relieved of the tax liability if:

(A)  A joint return has been made for a taxable year;
(B) There is an understatement of tax attributable to erroneous items of the other spouse filing the return;
(C)  The spouse seeking the innocent spouse relief establishes that he or she did not know, and had no reason to know, that there was an understatement;
(D)  Taking into account all the facts and circumstances it would be inequitable to hold the spouse liable for the deficiency attributable to such understatement; and
(E)  The spouse seeking relief elects innocent spouse status not later than two years after tax collection activities have begun with respect to that spouse.

If the spouse seeking relief cannot establish that he or she did not know or have reason to know of the understatement, that spouse may still obtain relief if he or she did not know or have reason to know the extent of such understatement. The relief will then be to the extent such liability is attributable to the portion of such understatement of which he or she did not know or have reason to know.

A spouse has knowledge or reason to know of an understatement if he or she either actually knew of the understatement, or if a reasonable person in similar circumstances would have known of the understatement.  Some of the facts and circumstances that are considered are:  1) the nature and/or amount of the erroneous item;  2) the couple’s financial situation;  3) the requesting spouse’s educational background and business experience;  4) the extent of the requesting spouse’s participation in the activity that resulted in the erroneous item;  5)whether the requesting spouse failed to inquire, at or before the time the return was signed, about items on the return or omitted from the return that a reasonable person would question, and 6) whether the erroneous item represented a departure from a recurring pattern reflected in prior years’ returns.

Julia Miessner, CPA, CFF

 

[1] Mochwart v. Mochwart, DC SuperCt FamDiv, 7/13/81;  Sheridan v. Sheridan, NJ SuperCt ChancDiv, No. M 05817 90;11/21/90.

 

[2] Excerpts From I.R.C. Section 6015(b)(1) and 6015(b)(2)

[3] Treas. Reg/ Sec. 1.6015-2