Every year, both in April and in October, divorce lawyers face a dilemma. While April is the official tax deadline, just about everyone knows that “complex” returns are almost never complete when spring rolls around and many filers defer to October. But, when couples split they often ask for the first time whether they should be filing jointly with their spouse. This often presents difficult questions for the lawyers because we are not accountants and we are latecomers to the financial history of the marriage. The easy answer is to say “Never!” in response to the inquiry, but that usually means the marital estate will have additional tax burdens. It also is often a financial shot across the bow of the primary breadwinner, causing aggravation that can set a decidedly negative tone to the negotiation process.
Inevitably, once the discussion about joint versus separate returns gets underway, one of the parties introduces another term, “innocent spouse.” For many years, if one spouse was seriously hedging in reporting income or by deducting improper expenses, the spouse who did not produce the income or determine the expenses could claim that they should not be held liable for the taxes, interest and penalties. This was because he or she did not know and could not reasonably have known about the tax evasion. It is an area where laypeople seem to think they are expert when they most certainly are not.
On Saturday, the Wall Street Journal reported on the story of Rick Jacobsen. Rick filed jointly with his wife. In 2012, the IRS found that Mrs. Jacobsen had embezzled about $500,000.00 from a non-profit where she did accounting. Most people don’t realize this, but if you steal money, the government classifies it as income and you owe taxes on it. So the IRS sent the joint filing Jacobsen’s an “assessment” for $100,000.00 in income tax due but unpaid. Jacobsen contested the assessment contending that he did not know about the “income” and should not be assessed for something his wife did without his knowledge. Last month the U.S. Tax Court agreed.
How come the IRS did not just get the money from Mrs. J? You know. She was in prison and the money had disappeared. So, Mr. Jacobsen filed his own Form 8857 and claimed he knew nothing about the income or the tax associated with it. He was underway when a new wrinkle emerged. His now “ex” told the Service he did know about the money taken. Innocent spouses are not innocent if they either knew about or “profited” from the wrongdoing spouse’s conduct. Thus, if you are reporting $4,000.00 a month in income and you are making mortgage and car payments of $5,000.00 a month, the term “innocent” may not fit comfortably around your financial neck. The IRS denied Herr Jacobsen relief and he appealed to the Tax Court, which heard his case in 2017. By the time the case was heard the tax due had swollen to $150,000.00 with penalties and interest. His happy news is that the Court decided for him on almost all of the unreported income.
How did he prevail against the government? First, he showed that he was financially unsophisticated. His wife was an accountant. He had an associate’s degree and worked in a cheese factory. Second, and most important, he could show that the money embezzled did not inure to his benefit nor was it apparent from his wife’s lifestyle. The couple did gamble a lot, reporting $160,000.00+ in gaming income and corresponding losses in one year. The couple filed electronically and husband said his only involvement in tax preparation was providing his W-2 wage statement to his wife. Not only did their lifestyle not improve, at one point their utilities were suspended for non-payment. The Tax Court accepted his testimony that his gaming activity was quite modest and involved only slots. One can picture the IRS attorney wincing during that testimony. The Court also did not credit wife’s testimony that her husband knew because it was not supported by any evidence.
Other intangibles are credited with his win as well. He is a disabled veteran who is no longer married to the offending taxpayer and aside from the issues associated with his joint filing, all other returns he filed showed income properly reported and taxes properly paid.
The Opinion reported as T.C. 2018-115, is worthy of review as the presiding judge marches through the statutory facts and case law to reach her conclusion. She found that husband was “out” for most of the tax liability arising from 2010, but had to pay tax on a small piece of unreported income in 2011 because he filed a joint return, even after his wife was charged with embezzlement. Note also that the case is decided under precedent from the Seventh Circuit Court of Appeals. Other Circuits may employ other standards or analysis.
Also important to know is the statistical trend. In 2013 there were roughly 35,000 innocent spouse cases presented for disposition. Relief was denied in just over 10,000 of those cases and granted in some form or the other in 25,000. In 2017 the number of requests had fallen to 25,000 and in that year the denial rate soared so that the chance of denial was equal to that of getting relief. As Sgt. Esterhaus said best, “Let’s be careful out there.” And, beware that the tale of an ill-advised joint return may come with a tail of never ending tax obligations.