Nine states treat income earned and property acquired during marriage as community property.[1] Under this doctrine, spouses generally share equal rights to and responsibility for income. Since spouses are taxed according to property rights granted under state law, income acquired in community property states is treated for federal tax purposes as being earned by each spouse; thus, each spouse would generally be responsible for paying federal taxes on half of community income, even if one spouse earned the majority of the income. Unless the couple files a joint return, this can result in one spouse having to pay taxes disproportionate to his or her individual income. To avoid this liability, a spouse can file Form 8857 to claim relief under Internal Revenue Code (IRC) § 66.[2]
Separated Spouses – § 66(a)
IRC § 66(a) relieves married people from federal tax responsibility for income earned by an estranged spouse. When spouses in a community property state have lived apart during the entirety of the calendar year, and have not shared income or filed a joint return, then certain types of income are treated as individual property.
- Earned income (e., payment for personal services actually rendered) is treated as the sole income of the spouse that rendered the personal services.
- Trade or business income is treated as the sole income of the spouse engaged in the trade or business, or, if the spouses jointly operate the trade or business, as the income of each spouse based on their respective distributive shares.
- Partnership distributions are attributed to the spouse receiving the distribution as net earnings from self-employment. Income derived from separate property is treated as the sole income of the owner.
- All other community income remains subject to normal community property rules.
Failure to Notify Spouse of Community Income – § 66(b)
In addition to relief based on separation of spouses, IRC § 66(b) grants the Secretary of State the discretionary power to disallow community property tax benefits to spouses that treat community income as their individual income and fail to notify their partners of the nature and amount of the income before the tax return filing due date. As explained by the Ninth Circuit, this is not a relief provision like the rest of § 66; rather, it “gives the Secretary the discretion to disallow a community property taxpayer from taking advantage of community property laws to the detriment of the taxpayer’s spouse.”[3]
Equitable Relief – § 66(c)
Finally, IRC § 66(c) grants relief based on equitable concerns. A spouse that files an individual return that excludes community income attributed to the other spouse in the same manner as § 66(a) is relieved of paying taxes on that community income when the filing spouse did not know, and had no reason to know, of the income, and it would be inequitable to attribute that income to the filing spouse. Additionally, a spouse may obtain relief from responsibility for unpaid taxes or deficiencies solely based on equity even if the requesting spouse had knowledge of the other spouse’s income.
IRS Revenue Procedure 2013-34 details threshold requirements and factors to be considered for obtaining relief solely based on equity.[4] As a threshold matter, a spouse requesting relief under a claim timely filed must not have exchanged any assets with the other spouse as part of a fraudulent scheme, nor can the requesting spouse have knowingly participated in a fraudulent filing.
The IRS may make a streamlined determination as to relief if the requesting spouse (1) is no longer married, (2) would suffer economic hardship if relief were not granted, and (3) did not have knowledge or reason to know of the community income. The requirement for lack of knowledge can be difficult to overcome, as mere awareness that the other spouse is engaged in an income-producing activity can count as knowledge under § 66(c) even if the requesting spouse is unsure of the exact amount of the income. If these elements are not satisfied, the IRS may still grant equitable relief after considering all of the facts and circumstances of the case.
The IRS has provided the following nonexclusive list of factors to consider in granting equitable relief:[5]
- Marital status of the requesting spouse,
- Economic hardship to the requesting spouse if relief is not granted,
- Whether the requesting spouse knew or had reason to know of the community income,
- Whether either spouse has a legal obligation to pay the outstanding Federal income tax liability (e.g., due to a divorce decree or settlement),
- The benefit, if any, to the requesting spouse from the unpaid income tax liability or understatement,
- The requesting spouse’s compliance with income tax laws in the years following the period for which relief is requested, and
- The requesting spouse’s mental or physical health.
Abuse suffered by the requesting spouse at the hands of the other spouse may also influence the weight given to each factor, and whether each factor will weigh for or against granting relief.
To ensure that a claim for relief under § 66 is timely resolved, a requesting spouse should file Form 8857 immediately after receiving notice from the IRS of an audit or outstanding liability against community property.
Representation in Tax Audits & Appeals
Need assistance in managing the audit process? Freeman Law’s team of attorneys and dual-credentialed attorney-CPAs regularly represents taxpayers before the IRS and Texas Comptroller. Our team also provides tax return-related representations and helps taxpayers navigate state tax laws. Our Firm offers value-driven services and provides practical solutions to complex issues. Schedule a consultation or call (214) 984-3000 to discuss our tax representation services.
[1] Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
[2] Request for Innocent Spouse Relief (and Separation of Liability, and Equitable Relief); see 26 C.F.R. § 1.66-4.
[3] Hardy v. C.I.R., 181 F.3d 1002, 1007 (9th Cir. 1999).
[4] See generally Rev. Proc. 2013-34, 2013-43 I.R.B. 397 (IRS RPR 2013).
[5] Id.
