When your client is concerned about the risk of being held liable for taxes on the income of his or her spouse, there are several options to be considered.
Married Filing Separate
If your client knows or fears the spouse plans to under report taxes due, you may want to recommend that your client file their tax return using the married filing separate status. When filing separately, each spouse’s share of taxable income and deductions is reported on his or her own return. Although married filing separate status has some disadvantages, it may be preferable when your client does not want to be exposed to the additional tax resulting from future tax assessments against the spouse. It may be possible that your client would qualify for head of household status, offsetting some of the disadvantage of the married filing separate status.
Another option is to insert an indemnification clause in the divorce decree whereby the spouse agrees to reimburse your client for taxes paid related to the spouse’s failure to report, and pay taxes due on a married filing joint return. However, this will only protect your client if they are able to collect on the indemnification agreement. Also, this does not stop the IRS from collecting the entire tax deficiency from your client. Joint and several liability cannot be averted by signing an indemnification agreement to which the IRS is not a party.
Yet another option is to set up an escrow arrangement that covers a reasonable estimate for tax contingencies. This can be helpful when a transaction has been entered into for which the tax consequences are undetermined at the time of the divorce.
Still another option may exist under the “separation-of-liability” Innocent Spouse Rules of IRC Section 6015. Although innocent spouse relief is available to all taxpayers, this option is carved out especially for divorced taxpayers. Under this provision, the tax liability of each spouse is calculated separately by allocating the income and deductions from the joint return to each spouse. In essence, this calculation amends a joint return into separate ones. To request separation-of-liability relief, the requesting spouse must have filed a joint return and meet one of the following requirements:
- The requesting spouse is no longer married to, or is legally separated from, the spouse with whom the joint return was filed; or,
- The requesting spouse was not a member of the same household as the spouse with whom the joint return was filed at any time during the prior 12-month period.
The IRS may or may not honor the request.
Steve Walker is a certified public account whose practice focuses on the financial end of family law matters. His practice is located in North Texas serving clients in Collin, Dallas and Denton Counties.