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: California Divorce and Family Law

IRS Makes It Tougher For Spouses to Claim Innocence in Tax Fraud

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It is getting harder to prove your innocence when you sign a joint tax return with your spouse that later turns out to be wrong or fraudulent -- due to a combination of tougher IRS enforcement, a string of recent court cases and ambiguous laws.

Most married couples file jointly, a strategy that typically saves taxes. But as thousands of taxpayers have discovered in recent years, signing a joint return can turn into a long-running nightmare when a spouse has neglected to report taxable income or committed some other offense.

In an "innocent spouse" defense, one spouse argues that he or she didn't know, and didn't have any reason to know, about any wrongdoing -- and shouldn't be responsible for paying the taxes due.

Lea Fastow, the wife of former Enron Corp. Chief Financial Officer Andrew Fastow, declined to mount that defense -- though her husband later implied she could have. She pleaded guilty in 2004 to filing a false joint tax return and subsequently spent a year in federal prison. In emotional courtroom testimony last week, Mr. Fastow choked up and wiped tears from his eyes, saying he had misled his wife about the source of some of the couple's money from an Enron-related deal.

"I find it hard to believe myself that she is guilty. I did mislead her," Mr. Fastow said.

Congress changed the innocent-spouse law in 1998 after protests from many victims, mainly women, who felt they were getting stuck with tax bills they didn't rightfully owe. The changes broadened the circumstances under which one can qualify for relief. Critics now say these protections, in the face of stepped-up IRS enforcement, are too weak to do the job Congress intended.

When you file jointly, both you and your spouse are responsible for any taxes, interest or penalties on those returns, with relatively few exceptions -- even if you later get divorced. That means the IRS typically can collect all the tax owed from either person.

That is true even if you signed a divorce decree saying the other spouse will be responsible for any taxes due on previously filed joint returns, the IRS says -- and even if all of the income was earned by the other person.

That is why tax advisers routinely advise clients never, ever to sign a joint return if the client suspects his or her spouse didn't play by the rules. While you may honestly believe you are innocent, proving it requires jumping over several hurdles.

To qualify for innocent-spouse relief, you have to demonstrate, among other things, that you didn't know -- and had no reason to know -- there was an understatement of tax. Proving you had no reason to know can be especially tough, especially if you are well educated. There are two other possible escape hatches, but they can also be difficult to get through, lawyers say.

The relief rules are "sometimes overly narrow, complex, costly for the IRS to administer and burdensome for taxpayers," the Taxpayer Advocate's report says.

Furthermore, even if someone is declared an innocent spouse and not liable for the other spouse's tax, the IRS still may be able to collect the other spouse's tax liability from the "innocent" person in community-property states such as California, the report says.

A Tax Court case decided last month shows it isn't enough simply to argue that your spouse prepared the taxes and didn't tell you how it was done, and that you didn't even review the return. The Tax Court rejected a Utah woman's request for relief, saying she knew, or should have known, about such issues as unreported income from her husband's business.

In another case decided in February, the court ruled against a North Carolina woman who said the tax debt was due to her ex-husband not paying his Social Security taxes. She said she had been told by her accountant to sign a joint return, even though she was separated, in order to "help with divorce relations" by lowering the amount he owed.

Needless to say, that was a bad idea. "I would advise anyone very strongly not to sign a joint return if they have a whiff of any impropriety," says Elizabeth Cockrell, a Colorado woman whose case helped lead to the 1998 tax-law change. "I'll never, never sign a joint return again," she says, "even if I were married to the commissioner of the IRS."

From the Wall Street Journal (subscription required)

Full post as published by California Divorce and Family Law on March 16, 2006 (boomark / email).

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