If you hear these words from a client, chances are that the story will be interesting.
By the time the client picks up the phone, he or she will have already: (1) Read the signals that something is amiss (anything from a questionable deduction to a bumper sticker proclaiming a spouse’s allegiance to a tax protestor group); (2) tried talking about it (interesting conversation) or decided not to bother (even more interesting); (3) decided that knocking on wood and hoping for the best may not be the best strategy; and (4) decided to act.
In the spirit of “First, do no harm,” a quick word on what not to do. If a client has reason to believe that his or her spouse is cheating on his taxes, the client should not, under virtually any circumstances, sign a joint return with the spouse.
The reason is simple: by signing a joint return, a married person becomes jointly and severally liable with his or her spouse for all of the taxes that the couple owes for the year. Unless he or she can qualify as an “innocent spouse,” which will be difficult to do if he or she knew or had reason to know of the understatement (I.R.C. § 6015), he or she will be jointly and severally liable for the entire tax bill. I.R.C. § 6013(d). Indeed, a person who knowingly signs an untrue joint return is guilty of a felony. I.R.C. § 7206.
The obvious (and indeed the only) alternative is to file as “married filing separately.” While this can result in a greater total tax liability than married filing jointly, it at least avoids the trap of joint and several liability plus a potential criminal conviction. If the innocent spouse files separately, correctly reports her individual income, and pays the resulting tax, she will avoid the quagmire hubby created. Correct?
Not quite. Like an undetected cross-current, California’s community property law may result in some unforeseen complications.
Because California is a community property state, absent a pre-maritial or post-nuptial agreement to the contrary, each spouse has an enforceable right to one-half of the total community income—i.e., the total income earned by both spouses. Therefore, your client cannot simply report his or her wages for the year and be done with it. Rather, he or she must report one-half of the total community income—client’s earnings plus spouse’s earnings—for the year. Mischel v. Commissioner (1997) T.C. Memo. 1997-350. This could be more or less than your client’s individual wages, depending on which spouse earns the most. (Another interesting conversation, no doubt.)
In practice, this means that your client must determine the spouse’s true income in order to file an accurate married-filing-separately return. If the spouse is a regular employee, your client may be able to sneak a peek at his or her Form W-2. Of course, the spouse is less likely to cheat if he or she knows that the employer will report his or her income to the IRS anyway. In the more likely event that the spouse is a self-employed contractor who takes cash under the table or overstates deductions, there may be no way your client can accurately determine the spouse’s income. This leaves your client in a classic Catch-22: the spouse’s failure to report income—the very reason your client needs to file separately—also makes it difficult for him or her to file an accurate return.
One potential solution is a marital property agreement under which the couple agrees that each spouse’s earnings will be his or her separate property. This gives only prospective relief. A valid marital property agreement will generally be respected for tax purposes. Helvering v. Hickman (9th Cir. 1934) 70 F.2d 985. Once the agreement is in place, your client will have the right to receive—and be liable for the taxes on—only his or her own earnings. Another possibility is to seek a legal separation.
Of course, your client cannot enter into a valid marital property agreement unilaterally—the spouse has to agree too. If the spouse is not interested, your client’s choices come down to: (1) end the marriage, in which case both spouses’ future incomes will be their separate property, or (2) file separate returns that report one-half of the community income as accurately as possible.
There is statutory relief in the nature of innocent spouse for those filing as married filing separate under §66. A spouse will not be held responsible for one-half of the other spouse’s income if the spouse did not have reason to know of the income or benefit from it.
While less than perfect, estimating community income as accurately as possible and filing a separate return may be the only real choice for someone who does not want to give up on a marriage to an uncooperative spouse. Your client could still be faced with an audit to determine the correct amount of community income, and may have to pay interest and accuracy penalties if he or she guesses wrong. But at least your client will have a fighting chance to minimize the cost of his or her spouse’s wrongdoing, and will not commit a felony in the process.
Jonathan C. Watts recently opened his own law office in San Ramon. He assists his clients with business transactions, corporate law, estate planning, and tax issues, and looks forward to completing his LL.M. in Taxation from the University of Alabama School of Law this summer.
Articles on Taxes from the Family Law practice area perspective:
- New Tax World for Registered Domestic Partners by Don Read
- Help! I Think my Spouse Is Cheating (On His Taxes) by Jonathon Watts
- Divorce, Children and Taxes by Leslie Dawson, CPA
Filed Under: Spotlight