Separate Liability Election

This rule is considerably more liberal than the innocent spouse rule, with one exception: this rule isn’t available if you’re still married and living with your spouse. You may escape liability in circumstances where you wouldn’t otherwise qualify. But you can still be stuck if you signed a return you knew was wrong. What’s more, even if you qualify for relief, you may have to pay some of the tax, as explained below.

Requirements for relief

There are three requirements for relief under this rule. These requirements look to the status of your marriage, your actual knowledge of the incorrect item on the return, and any asset transfers from your spouse or former spouse.

Status of your marriage. You aren’t eligible for the separate liability election unless one of the following is true:

• You’re divorced or legally separated from the person with whom you filed the joint return.
• The person with whom you filed the joint return has died.
• You haven’t been a member of the same household with that person at any time in the 12-month period ending on the date you filed the election.

If you don’t meet this requirement you can still attempt to qualify under the Innocent Spouse Rule or request Equitable Relief.

No actual knowledge. Relief doesn’t apply to any item your spouse reported incorrectly if you had actual knowledge that it was incorrect at the time you signed the return. The IRS has the burden of demonstrating that you had actual knowledge, however, and it isn’t enough for the IRS to show that you should have known about the error. In addition, actual knowledge won’t disqualify you if you can show that you signed the return under duress.

Fraudulent scheme. Relief under this rule isn’t available if one spouse transfers assets to the other as part of a fraudulent scheme. Obviously, the rule is designed to prevent unfair tax collection — not to permit unfair tax avoidance. If the IRS can demonstrate the existence of a fraudulent scheme, you’re completely disqualified from relief under the separate liability election.

Applying for relief

The IRS won’t automatically grant you relief under this provision, even if you clearly meet all the requirements described above. You have to elect this treatment by filing Form 8857, Request for Innocent Spouse Relief with the IRS. (This form is used for the separate liability election as well as innocent spouse relief.)

You must apply for relief within two years after the date the IRS begins collection activities against you. You can apply for this relief even if you qualify for, and apply for, relief under the Innocent Spouse Rule. If the IRS says you don’t qualify for relief, you can petition the Tax Court to determine whether the IRS is correct.

Effect of relief

If you meet the requirements described above, then you can elect to limit your liability to your share of the tax liability, as explained below. In the typical case, the spouse who failed to report properly will end up with the liability.

Example: The IRS audits your joint return and finds that your spouse omitted some income. The audit occurs when you’re no longer married to that individual and you make the separate liability election. The unreported income was earned by your former spouse, so your former spouse would have sole responsibility for the tax deficiency.

As you’ll see, however, there are situations where you could still end up paying at least some of the tax when your spouse claimed an erroneous deduction or credit.  In doubtful situations, the burden of proof is on you (not the IRS) to prove how much of the tax deficiency is your share. There are five steps to determine how liability is divided on a joint return:

Step 1: Whose Item Is It?

Begin by determining, as to each item the IRS is adjusting, which spouse would have reported the item if you filed separately. (If there’s a rule that says you aren’t allowed to claim this type of item when filing separately, ignore that rule for this purpose.)

Note: The IRS can change the way the items are divided between the spouses if the change is appropriate because of fraud by one or both spouses.

Step 2: Who Received the Benefit?

If the item that’s being adjusted produced a tax benefit for the other spouse, allocate some or all of it to that other spouse.

Example: Suppose the IRS disallows a $20,000 deduction from the husband’s business, but the correct amount of income for the husband was only $15,000. In that case, $5,000 of the deduction produced a tax benefit for the wife, so the rule will allocate $5,000 of this item to her.

Step 3: Credits and Certain Taxes

Next, check to see whether any of the tax liability relates to a tax credit or liability for a tax other than the income tax or the alternative minimum tax (AMT). Allocate these items to the appropriate spouse (as determined in Steps 1 and 2) before applying the formula described in Step 4. For example, if one spouse failed to report self-employment tax liability, that spouse will have full responsibility to pay the resulting shortfall.

Step 4: Allocate the Remaining Liability

Now allocate liability for items other than those described in Step 3 in proportion to the dollar amount of those items allocated to each spouse. For example, if one spouse failed to report $7,000 of income and the other spouse claimed an erroneous deduction of $3,000, allocate the tax liability 70% to the first spouse and 30% to the second spouse. These percentages apply even if part of the deduction didn’t produce a tax benefit (for example, it was a miscellaneous deduction that was allowed only to the extent that it was greater than 2% of adjusted gross income).

Step 5: Transfers of Disqualified Assets

Your liability as determined in the preceding steps will be increased by the value of any disqualified asset transferred to you. A disqualified asset is any cash or other property (or right to property) transferred to you by the other person making the joint return if the principal purpose of the transfer was tax avoidance. There’s a presumption that asset transfers have this purpose if they’re made on or after the date the IRS proposes a deficiency — or within a year before that date. But the presumption doesn’t apply to transfers that occur as part of a divorce, or any other transfer if you can show the principal purpose wasn’t tax avoidance.

Note: This rule is separate from the rule mentioned earlier under which the IRS can deny relief if it shows that you’re engaged in a fraudulent scheme to avoid taxes. Under this rule, the IRS doesn’t have to demonstrate fraud, which is usually difficult to prove. If you receive cash or other property from your spouse (other than in a divorce), you have to show that the transfer wasn’t part of a tax avoidance scheme.

Unpaid Tax

This rule does not provide relief from an unpaid tax on a correct return. If you signed a correct return and your spouse failed to pay the tax, a separate liability election won’t help you. But you may be able to obtain Equitable Relief.