Practice Alert: Does That Divorce Strategy Spell Tax Disaster?

By: Robert T. Leonard, J.D., C.P.A.

She looks like just the average divorce client as she sashays in your door. Dabbing her eyes with a handful of tissue, she begins by telling you that her soon-to-be ex owns a successful sole proprietorship – or perhaps a thriving closely-held corporation.

“And I think he makes considerably more money than he reports,” she confides. “So let’s try to get him to agree to generous child support and alimony.”

Think that the possibility of unreported income might offer great leverage for a favorable settlement? Confident that your client – who appears to have no actual knowledge of underreporting – will be sheltered by the “innocent spouse” rules? Better think again. For the unwary practitioner, what just crossed your threshold could be a malpractice suit in disguise – or even worse.

Here’s why. If those allegations are true, the behavior your client is describing is serious tax fraud – in which, even without actual knowledge, she may be deemed to have knowingly participated. Unfortunately, in their zeal to maximize a client’s settlement, divorce counsel often overlooks the fact that the award won’t be consistent with previous tax returns.

Taking the “Innocent” Out of Innocent Spouse Protection

So let’s say you’ve just drafted an interrogatory demanding to know the exact size of the husband’s business assets or his corporation’s actual monthly or annual income (since, after all, your client wants half). Or you ask the other side to produce a monthly financial statement that you expect will contain numbers glowing far brighter than those compiled on the couple’s tax return.

Sure you’re helping your client build a great case for a sizeable settlement. But she could also be building herself a great case for tax fraud – and against protection under the “innocent spouse” rules. I.R.C. Sec. 6013(e).

The risk is all too real. Spouses who file a joint tax return may be held jointly and severally liable for tax deficiencies, interest, and penalties attributable to underreported income. But the downside can get even worse; where underreporting was willful, a client can also face criminal sanctions. And information attesting to significant cash transactions may even expose one or both spouses to civil and criminal money-laundering liabilities.

Thanks to the Internal Revenue Service’s “Financial Status” audit technique, agents are now trained to scrutinize court documents for evidence of under-reported income. Judges, too, are increasingly alert, and may refer a case for criminal prosecution if they see evidence of tax fraud.

That means prudent counsel should be careful what they and their clients document in pleadings and in on-the-record testimony. Picture your client on the witness stand, stating under penalty of perjury that her husband has regularly been non-reporting $100,000 in income a year. Now picture the husband taking the stand in rebuttal, swearing that he’s “only” been non-reporting a token $25,000 a year. With your eye only on alimony, that may sound like a relatively routine – even humorous – tactical exchange. But it won’t be funny when the IRS comes knocking.

Not to worry, you think. Your client can claim “innocent spouse” protection. After all, they can’t prove what she knew.

But hold on – this cavalier assumption can backfire. Even absent proof of actual knowledge of the unreported income, your client may still be presumed to know of it, for example, she spent sums freely that would be at variance with reported income. That’s because, under IRS regulations, the spouse will be presumed to know if she had knowledge or reason to know of the underreporting. She may have been spending a lot more money than the total reported, for example, without asking questions. Putting one’s head in the sand is no defense.

Practitioners also may not realize that it remains very difficult to qualify for innocent spouse protection. But there has been one bit of good news on the “innocent spouse” front recently; Congress recently liberalized the protective provisions in the 1998 Restructuring & Reform Act, changes that provide taxpayers with significant new options. Code Section 6015 now offers three important options for spouses seeking relief from joint and several tax liabilities:

• Relief on traditional “innocent spouse” grounds;
• A new “separate liability” election for taxpayers who are no longer married or who have separated; and
• “Equitable” relief for those who deserve it, based on the surrounding facts and circumstances.

The net effect of these changes has been to expand spousal relief, thus allowing the relief that Congress intended.

Even with this broader statutory language, however, practitioners should note that it is still difficult to establish a client’s entitlement to relief. It is vital that counsel accurately predict whether their client will qualify under the innocent spouse test.

Before relying on “innocent spouse” protection for your client, make sure you’re right – because if you’re wrong, your client could go to jail. Even if you’re right and your client truly qualifies for innocent spouse relief, are you sure your client wants to risk initiating a criminal investigation into her husband’s affairs? The costs of defending himself from such an investigation, including attorneys’ fees, stress and distraction may not be best for family, his kids, or his ability to continue making child support and alimony payments – especially if he ultimately goes to prison.

Avoiding Practice Traps

So what’s a prudent family law attorney to do? In a marital dissolution matter, make sure you obtain copies of prior years’ tax returns and pay attention to what assets and income were declared. If you know – or strongly suspect – that your client is dealing with a financial picture that wasn’t clearly reflected on past tax returns, get a handle on the potential tax and criminal implications early in the matter.

You may wish to consider associating an experienced tax counsel to help you evaluate such issues as:

• How likely is it that your client will be able to successfully claim “innocent spouse” relief?
• What are the potential implications of a particular discovery request or disclosure?
• Should your client elect to file a joint or separate tax return during the pendency of the divorce?
• What are the benefits – and downsides – of amending previous tax filings to voluntarily disclose previously unreported income?

Sound tax advice cannot only help you alert your client to potential pitfalls down the road, but can help you to avoid future malpractice suits. If, for example, your client decides to demand support based on actual (but unreported) income, both you and she need to clearly understand the risk outlined above. Also, a generous support award may in effect encourage continued non-reporting by the income-earner to support this new obligation, behavior that leaves your client (and her future income) in possible jeopardy. On the other hand, if she does not use suspected unreported income to compute her award, she will probably get lower support as it would be based on lower income.

Family law attorneys need to carefully evaluate the ramifications of “on-the-record” financial disclosures in a marital dissolution, and should use caution before concluding that “innocent spouse” protections will truly protect their clients from the consequence of past-unreported income.