By Arden Dale
When the IRS decides a tax return is wrong, someone has to pay. More spouses and ex-spouses are trying to make sure it isn’t them.
They are invoking the “innocent spouse rule” in the tax code, which lets a wife or husband who wasn’t actively involved in preparing the return off the hook for taxes and penalties when an audit finds errors. This tactic is getting more controversial, however, as it grows in popularity.
Congress gave more leeway to the innocent spouse rule in 2004, prompting more people to use it, tax lawyers. Now courts are in a ping-pong game over the provision.
The innocent spouse rule is “probably one of the most litigated statutes in the history of the tax code,” says David L. Rice, a professor of taxation at California Polytechnic State University at Pomona.
Right now, court cases are being fought over how long someone has to seek protection after the Internal Revenue Service starts trying to collect.
Another question is who exactly qualifies as an innocent spouse. Circuit courts have issued rulings that conflict both with other circuits and with the U.S. Tax Court.
One lesson is clear: Turning a blind eye to what the other half is doing with the tax return is a set-up for trouble.
Tax lawyers still talk about one old case, that of Kathryn Cheshire, who was denied an appeal after the IRS wouldn’t let her claim the innocent spouse rule over a return prepared by her ex-husband, David Cheshire. Its outcome prompted the moniker “The Cheshire Grin” in tax circles.
David retired from Southwestern Bell Telephone Co. in 1992, and put the bulk of his $230,000 in retirement distributions into an interest-bearing checking account and not a qualified retirement account. He used nearly $100,000 to pay off his mortgage and $20,000 to buy a new family car.
On a joint tax return, which David Cheshire prepared, they reported nearly $200,000 in retirement distributions but only $56,150.12 of this amount as taxable. The couple separated in 1993 and divorced 17 months later. The IRS audited the return, and said the Cheshires had understated their taxable distributions by $131,591 and interest by $717, and imposed a penalty.
Kathryn said David had told her a CPA assured him that some of his retirement proceeds were nontaxable. So, she argued, she shouldn’t be liable for what the couple owed. The Tax Court said she wasn’t an innocent spouse because she knew about the retirement money and where it was spent. Her defense, the Court concluded, consisted only of “her mistaken belief” that money spent to pay off a mortgage is properly deductible from retirement distributions.
“Ignorance of the law cannot establish an innocent spouse defense,” it said in court documents.
Typically, in instances of divorce the strategy is easier to employ than when a couple is still married. It gets complex, but generally, a still-married spouse must show innocence, while it is up to the government to prove guilt if the person is already divorced.
The difference is stark enough that Robert E. McKenzie, an attorney in the Chicago law firm Arnstein & Lehr LLP, has counseled some estranged spouses to “wait until divorce is final and we’ll get an easier standard on innocent spouse.”
Readers, do you think spouses should be off the hook for taxes and penalties when an audit finds an error, but they didn’t prepare the tax return?