Spouse’s Actual Knowledge

Unless a return is signed under duress and this can be proven, if IRS demonstrates that an electing spouse had actual knowledge, at the time he signed the return, of an item giving rise to all or part of a deficiency that isn’t allocable to that spouse under the allocation rules, the separate liability election won’t apply to that part of the deficiency. In that case, Congress expects that the item of which the spouse had knowledge will be fully allocated to both spouses.

As an example: A married couple files a joint return with wage income of $150,000 allocable to the wife and $30,000 of self-employment income allocable to the husband. On examination, an additional $20,000 of the husband’s self-employment income is discovered, resulting in a deficiency of $9,000. IRS proves that the wife had actual knowledge of $5,000 of this additional self-employment income; she had no knowledge of the remaining $15,000.

The husband is liable for the full amount of the deficiency, since the item giving rise to the deficiency is fully allocable to him. In addition, the wife is liable for the amount that would have been calculated as the deficiency based on the $5,000 of unreported income of which she had actual knowledge. IRS could collect that amount from either spouse, while the rest of the deficiency could be collected only from the husband.

If IRS demonstrates that the requesting spouse had actual knowledge when the return was signed of an erroneous item that is allocable to the other spouse, the election to allocate the deficiency attributable to that item is invalid, and the spouse remains liable for the portion of the deficiency attributable to that item. In order to invalidate the election, IRS has the burden of both production and persuasion and must establish by a preponderance of the evidence that the requesting spouse had actual knowledge of the erroneous item.

For omitted income cases, knowledge of the item includes knowledge that the item was received. For example, assume W received $5,000 of dividend income from X Co., but W did not report it on her joint return. H knew that W had received $5,000 of dividend income from X Co. that year, and therefore H had actual knowledge of the erroneous item. Therefore, no relief is available for the deficiency attributable to the dividend income from X Co. This rule applies equally when the other spouse has unreported income but no actual receipt of cash (e.g., dividend reinvestment or a distributive share from a flow-through entity shown on Schedule K-1, “Partner’s Share of Income, Credits, Deductions, etc.”).

Actual knowledge of the proper tax treatment of an item is not relevant for purposes of demonstrating actual knowledge of an erroneous item. For example, assume H did not know W’s dividend income from X Co. was taxable, but knew that W received the dividend income. Separate liability relief is not available. Also, a requesting spouse’s knowledge of how an erroneous item was treated on the tax return is irrelevant to determining whether the requesting spouse had actual knowledge of the item. If H knew of W’s dividend income, but H failed to review the completed return and did not know that W omitted the dividend income from the return, then separate liability relief is not available.

As an Example: H and W, who file their Year 1 joint federal income tax return on Apr. 15, Year 2, report W’s self-employment income, but not the self-employment tax on that income. In July of Year 3, H and W divorce and in Aug., they receive a 30-day letter proposing a deficiency for the unreported self-employment tax, which is an erroneous item allocable to W. On Nov. 4, Year 3, H, who otherwise qualifies to make a separate liability election, files an election to allocate the deficiency to W. H knows that W earned income in Year 1 as a self-employed musician. Although H does not know that self-employment tax must be reported on and paid with a joint return, his election to allocate the deficiency to W is invalid nonetheless because he had actual knowledge of W’s self-employment income when he signed the joint return. That he was unaware of the tax consequences of that income (i.e., that an individual is required to pay self-employment tax on that income) is irrelevant.

If a requesting spouse has actual knowledge of only a portion of an erroneous item, then relief won’t be available for that portion of the erroneous item. For example, if H knew that W received $1,000 of dividend income, but did not know that she also received an additional $4,000 of dividend income, relief would not be available for the portion of the deficiency attributable to the $1,000 of dividend income of which H had actual knowledge.

To demonstrate that a requesting spouse had actual knowledge of an erroneous item at the time the return was signed, IRS may rely on all of the facts and circumstances, including (1) whether the spouse deliberately tried to avoid learning about the item in order to be shielded from liability or (2) whether both spouses owned the property that resulted in the erroneous item. The first factor, together with all other facts and circumstances, may demonstrate that the spouse had actual knowledge of the item and the spouse’s election will be invalid for the entire item.

As an Example: H and W are legally separated. In Feb. of Year 2, W signed a blank joint federal income tax return for Year 1 and gave it to H to fill out. The return was timely filed on Apr. 15, Year 2. In Sept. of Year 4, H and W receive a 30-day letter proposing a deficiency for $100,000 of unreported dividend income H received on his stock of ABC Co. W knew that H received the $100,000 dividend payment in Aug. of Year 1, but she did not know whether H reported that payment on the joint return. W files an election on Jan. 30, Year 5 to allocate the deficiency from the Year 1 return to H. W claims that she did not review the completed joint return, and therefore, she had no actual knowledge that there was an understatement. Nonetheless, W’s election to allocate the deficiency is invalid because she had actual knowledge of the erroneous item of dividend income when she signed the return; it is irrelevant that she signed a blank return. The election would also be invalid if W had not reviewed the completed return or had reviewed it but had not noticed that the item was omitted.

The second factor, joint ownership, supports a finding that the requesting spouse had actual knowledge of an erroneous item. But a spouse will not be considered to have an ownership interest in an item based solely on the operation of community property law except if the spouse resided in a community property state at the time the return was signed and the spouse’s name appeared on the ownership documents, or there otherwise is an indication that the requesting spouse asserted dominion and control over the item. For example, assume H lives in State C, a community property state with his wife, W. After their marriage, H opens a bank account in his name only. Under the laws of state C, W owns ¹/₂ of the bank account, but under the regs, W does not have an ownership interest in the account because the account is not held in her name and there is no other indication that she asserted dominion and control over it.

Knowledge of the source of an erroneous item is not sufficient to establish actual knowledge. For example, assume H knew that W owned X Co. stock, but H did not know that X Co. paid dividends to W that year. H’s knowledge of W’s ownership in the stock of X Co. isn’t sufficient to establish H’s actual knowledge of the dividend income. Also, a spouse’s actual knowledge cannot be inferred when the spouse merely has reason to know of the erroneous item, so that even if H’s knowledge of W’s ownership interest in X Co. indicates that H had reason to know of the dividend income, actual knowledge of the dividend income can’t be inferred from H’s reason to know. Similarly, IRS need not establish that a requesting spouse knew of the source of an erroneous item in order to establish that the requesting spouse had actual knowledge of the item itself. For example, assume H knows that W received $1,000, but does not know the source of the money, and W and H omit the $1,000 from their joint return. H has actual knowledge of the item giving rise to the deficiency ($1,000), and relief is not available.

As an Example: H and W are legally separated. In June of Year 3, a deficiency is proposed for their Year 1 joint federal income tax return that is attributable to $30,000 of unreported income from H’s plumbing business that should have been reported on a Schedule C. No Schedule C was attached to the return. When W signed the return, she knew that H had a plumbing business but did not know whether H received any income from the business. W’s election to allocate the deficiency to H is valid.

Another Example:The facts are the same as in Illustration (4) above, except that, when W signed the return, W knew that H received $20,000 of plumbing income. W’s election to allocate to H the deficiency attributable to the $20,000 of unreported plumbing income that W had actual knowledge of is invalid, but her election to allocate to H the deficiency attributable to $10,000 of unreported plumbing income she did not know about is valid.

Another Example: Again, the facts are the same as in Illustration (4) except that, when W signed the return, she did not know the exact amount of H’s plumbing income, but did know that he received at least $8,000. W’s election to allocate to H the deficiency attributable to $8,000 of unreported plumbing income (of which W had actual knowledge) is invalid, but her election to allocate the deficiency attributable to the remaining $22,000 of unreported plumbing income of which she did not have actual knowledge is valid.

Another Example: A husband, who didn’t qualify for relief as an innocent spouse because he had reason to know of omitted income, nonetheless qualified to make the separate liability election, because IRS didn’t offer any evidence that the husband had actual knowledge of the omitted item.