In the United States, only nine states recognize the concept of “community property:” Washington, Idaho, Wisconsin, California, Nevada, New Mexico, Arizona, Texas and Louisiana. The remaining states defer to the “title” in which property is held or income earned. In community property states, the marital relationship is referred to as the “marital community” and each member of that “community” is treated as an undivided one-half partner in income of the other partner. This fictional “marital community” may result in significantly different tax consequences if the parties do not file jointly. In community property states, each spouse reports only one half of his or her income, but must also report one half of the other spouse’s income. This may seem like an easy task, but for couples who remain married but no longer live together, or worse yet, refuse to speak to one another or cooperate in any way, this can quickly become a tax nightmare. Luckily, Congress has thought of, and provided for, this problem…sort of.
Relief from the Community Income Reporting Rule Under IRC §66(a) or (b)
Under Section 66(a) of the Internal Revenue Code, in certain circumstances a married couple can “qualify” to be taxed as though they live in a non-community property state and thus avoid being required to divide their incomes for reporting purposes. In order to qualify for this treatment, the couple must: (1) be married, (2) live apart, (3) have earned income, (4) not file a joint return, and (5) cannot have made any transfers of community earned income during the tax year. If a taxpayer fails any one of these tests, the taxpayer will not be granted relief under IRC §66(a) from the community income reporting rules. Even if a taxpayer fails to qualify for relief from the community income reporting requirements under IRC §66(a), however, a taxpayer may still qualify for relief from the community income reporting rules under IRC § 66(b). Under IRC § 66(b), the IRS may disregard the community income reporting rules if the earning taxpayer spouse establishes that he or she acted as if the income was not subject to community income rules (e.g., paid tax on the income) and failed to notify his or her spouse of the income.
Section 66(c) Innocent Spouse Provision
If a taxpayer fails to qualify under IRC § 66(a) or (b), there still may be a chance for relief from the community income reporting rules under Section 66(c). IRC § 66(c) has been referred to as the “Innocent Spouse” provision because it mirrors a number of the features of IRC § 6015’s innocent spouse provisions.
Under Section 66(c) a spouse will not be required to pay the unpaid tax on income that, under the community income rules, would be allocated to that spouse. Instead, tax on the portion of income allocated to the spouse under the community income rules will be re-allocated to the spouse who earned the income. The earning spouse will then be required to pay the tax on that income as if she or he did not earn the income in a community property state. In order for a taxpayer to qualify for relief under IRC § 66(c) as an “innocent spouse:” (a) the taxpayer must not have filed a joint return for the tax year during which the omitted income was allocated to her or him; (b) the taxpayer must show that he or she did not know or have reason to know of the omitted income earned by her or his spouse; and (c) the taxpayer must show that it would be inequitable to hold him or her liable for the tax on the income of the other spouse.
The Meaning of Equitable Relief
In 2003, the IRS issued Revenue Procedure 2003-61, which set forth the IRS’s criteria for awarding “equitable” relief. Revenue Procedure 2003-61 identified the IRS’s threshold requirements for granting equitable relief under IRC § 66(c). It then listed factors that it would consider when deciding whether to grant relief, but that are not necessarily determinative, or even the only factors that could be considered. The IRS’s threshold requirements for granting equitable relief include a 2-year statute of limitation from the date the IRS begins collection proceedings, a prohibition of fraudulent type transfers between the spouses or transfers that result in avoiding the payment of tax, a determination that the liability is attributable to the individual requesting relief, and confirmation that the requesting individual did not fail to file or pay because of fraudulent intentions.
Under Revenue Procedure 2003-61, the non exclusive factors the IRS will consider in deciding whether to grant equitable relief include: (1) the current (i.e., at the time of the request) marital status of the parties; (2) whether economic hardships are present or will result if relief is denied; (3) the requesting individual’s knowledge of the tax liabilities, including whether the requesting individual had a reason to know of the income but neglected to acknowledge any potential tax implications; and (4) whether the requesting individual attempted to comply with tax laws in subsequent years. The IRS also indicated that it would consider instances of abuse and mental or physical health when looking at whether the requesting spouse had knowledge of or a reason to know of the tax issues.
An Update To Equitable Relief Guidance
Recently, the IRS released Notice 2012-8, which reported that the IRS intends to update the 2003 Revenue Procedure 2003-61. Notice 2012-8 acknowledges the increase in equitable relief requests and that Revenue Procedure 2003-61 is outdated. Notice 2012-8 contains three main provisions.
First, Notice 2012-8 states that the IRS intends to address more completely how abuse and the lack of financial control may impact the marital community and the ability to influence matters such as tax reporting requirements or the ability to gain the requisite information to make accurate returns. The IRS acknowledges that there are circumstances where the requesting individual may not have been able to challenge the treatment of items, question the payment of taxes or challenge the other spouse’s assurances that taxes have been properly filed and paid. Notice 2012-8 states that the IRS intends to acknowledge that abuse or lack of financial control is a mitigating factor that can be weighed against other factors in deciding whether equitable relief should be granted.
Secondly, Notice 2012-8 states that, because there has been a significant increase in equitable relief requests, the IRS is in the process of developing a means of expediting relief for those taxpayers who can show: (1) that they are no longer married to the non-requesting spouse; (2) that they would suffer an economic hardship if relief were denied; and (3) that they had no knowledge or reason to know of the income not reported or tax not paid, or that they suffered abuse such that they lacked financial control and did not know about the income not reported or tax not paid.
Finally, Notice 2012-8 highlights a recent change that effectively extends the statute of limitations for claiming equitable relief. Relief can now be requested at any time the IRS can pursue collection under I.R.C. § 6502, which is typically ten years. Equitable relief can also be requested within 3 years of the date the returns were filed or 2 years from the date the tax was paid.
Equitable relief under I.R.C. § 66(c) is best claimed by filing a Form 8857 with the IRS. Form 8857 can be found at
www.irs.gov. It should also be noted that the IRS is still seeking comments on the proposed changes highlighted in Notice 2012-8.
About the Author
Mark Schwarz served as an attorney for the IRS Chief Counsel’s Office from 2005 to 2011. At Helsell Fetterman, his core practice includes tax controversy, tax planning, business and real estate transactions and estate planning.