Family, Friends, Heirs, and the IRS

The tax laws contain special rules affecting folks related by blood or marriage, and people who own property together. A taxpayer’s responsibilities don’t end with his death—his family may inherit his tax troubles. Maybe the old saying should be changed to “Nothing is certain except death and MORE taxes.”

It’s a Family Affair

If you are married, divorced, or a parent, familiarize yourself with some special tax rules.

Filing Tax Returns—Joint or Separate?

Married couples always have the option of filing a joint tax return or filing separate tax returns. And, if only one spouse has income, the other doesn’t have to file a return—although filing jointly will likely result in a tax savings. The only qualification for filing jointly is that the couple be legally married as of December 31 of that year. Occasionally, it pays, tax-wise, for married couples to file separate returns. However, taxes are higher in most instances, especially in community property states. This is because each spouse is considered to have earned 50% of the other spouse’s income for tax purposes. If in doubt how to file, calculate your tax liability both ways each year. Computer tax programs can do this very quickly.

caution

Each spouse is 100% liable for all the taxes owed on a joint return. But only the spouse in whose name a separate return is filed is liable for his or her income taxes. So, another reason some married couples file separate tax returns is to relieve each other of direct financial responsibility if the IRS should audit one of them, or if one can’t pay a tax bill.

Example 1:

Leon and Margaret are married and always file their tax returns jointly. Leon owns a dry cleaning business which reported an operating loss on their tax return. The couple was audited, and the IRS discovered that the business income was understated by $50,000. Leon and Margaret didn’t pay the resulting $22,000 bill and the IRS filed a lien against both of them. The IRS may collect on it from any jointly or separately owned property of either Leon or Margaret.

Example 2:

Now assume that Leon and Margaret file separate tax returns. Leon filed the phony tax return, but Margaret’s return showed only her wages as an office manager. Both returns were audited. Margaret’s audit resulted in no change. Leon was slapped with a $22,000 bill. The IRS filed a lien, damaging only Leon’s credit rating and subjecting only his assets to collection. Margaret is in the clear.

The Innocent Spouse Rule

The “innocent spouse” rule is the one exception to the law making both currently married or former spouses responsible for an IRS debt. (Internal Revenue Code § 6013(e).) A spouse, or more commonly, an ex-spouse, may be relieved of joint tax debts incurred after July 22, 1998 (the effective date of major changes to the law), as well as joint tax debts incurred before that date but paid afterwards.

Under the current rule, an innocent spouse filing a joint tax return must show:

  • all or part of the tax understatement was due to erroneous items of the other spouse

AND

  • he or she did not know, and had no reason to know, there was an understatement by the other spouse

AND

  • it would be unfair to hold the innocent spouse liable.

Even if a spouse does not qualify, the IRS can grant partial relief by apportioning the tax bill. The IRS will allow the “partially” innocent spouse to recompute his or her separate tax liability (what would be owed under a separate return) and owe just that amount.

The IRS can deny innocent spouse relief if it concludes that the spouse had actual knowledge of the tax misdeed and still voluntarily signed the return. The only hope for the innocent spouse is to show that he or she signed the return under duress.

Prior to July 22, 1998, it was harder for a spouse to avoid liability for joint tax debts. In addition, the IRS couldn’t grant proportional liability like it can under the current law—it was all or nothing. Under the old law, a spouse would be relieved of the tax debt only if:

  • the tax bill was for unreported income or overstated deductions of at least 25% of the total income originally reported

OR

  • there was a substantial understatement of tax attributable to grossly erroneous items of only one spouse

AND

  • the couple filed a joint return

AND

  • the spouse claiming to be innocent did not know about the unreported income or overstated deduction, and had no reason to know about it, and did not benefit from it (this benefit rule disqualifies most innocent spouses)

AND

  • holding the innocent spouse responsible would be unfair.
caution

The pre–July 22, 1998 innocent spouse rule is strictly applied. Neither the IRS nor the courts readily accept pleas of innocence under this law. In one case, the tax court denied a wife’s claim of innocence, although she had not known of her husband’s tax cheating. The court reasoned that she should have known that the income reported on her joint return was way too low to support her family’s lifestyle. Perhaps, if the husband had squirreled the nontaxed lucre away and clothed his wife in rags, she would have won.

Usually, innocent spouse claims are made by divorced taxpayers. People who are still married, however, can also use the innocent spouse rule.

Example:

Francisco and Imelda filed a joint return, were audited, and were found to have substantially underreported Francisco’s business income. Francisco had skimmed about $60,000 from his delicatessen. Imelda convinced the IRS that she was an innocent spouse—she knew nothing about the income, had no reason to know about it (she was in the hospital recovering from surgery when Francisco did their taxes), and did not benefit from it (Francisco blew the money gambling)—and so it would be unfair to hold her liable. Francisco changed his ways, and the marriage survived. Imelda went back to work and, using her good credit, bought a home and obtained a mortgage in her name alone. She and Francisco lived there, and he entered into an installment payment plan with the IRS for the taxes.

File IRS Form 8857 to request innocent spouse relief. The form is available online at the IRS website (www.irs.gov).

Tax Court for Innocent Spouses

Were you denied innocent spouse relief by the IRS? You can sue the IRS in tax court. (Internal Revenue Code § 6015.) You must file your petition within 90 days of the IRS denial notice date. Until the court decides, the IRS may not take any collection action against you. (See Chapter 5 for details on going to tax court.)

Divorce and the IRS

Alimony—Deductible and Taxable

Several tax issues arise at divorce. Alimony, sometimes called maintenance or spousal support, is one. Payments are tax deductible to the payer and taxable income to the recipient. Alimony must be specifically ordered by a court or in a legally binding written agreement signed by both spouses. Otherwise, payments to a spouse aren’t deductible and the other spouse does not have to report them as income.

If you get alimony, you can deduct any attorneys’ fees paid to secure or collect it. And professional fees for attorneys, accountants, and financial planners for advice on tax consequences of a divorce are tax deductible to both sides.

Marital Settlement Agreements

Divorcing couples often agree to issues of property division, debt allocation, alimony, and child support in a writing called a marital settlement agreement, dissolution agreement, or separation agreement. One item that should be covered is who pays any joint tax liability—past taxes, taxes currently owed, or any that may be assessed in the future for a period during marriage.

The IRS is not bound by marital settlement agreements with regard to tax debts. The IRS can pursue either spouse, no matter what the agreement says. Of course, if the party liable under the agreement doesn’t pay the tax bill and the other one does, the person who paid can sue the other in state court for reimbursement. Good luck.

You might escape joint liability for taxes by claiming innocent spouse relief. You must be divorced, legally separated, or not living in the same household for the last 12 months. You might escape the tax completely, or at least have it reduced to your proportional share.

Parenting and the IRS

The IRS seems to pop up in all areas of our lives, including parenting. Here are the rules on child support and the dependency deduction.

Child Support—Is it Deductible?

No. Unlike alimony, child support is neither deductible for the paying parent, nor reportable as income for the custodial parent. If you pay or receive family support—alimony and child support combined as one payment—you can deduct, or must report as income, only the alimony portion. Make sure your settlement agreement or court order distinguishes between the two—many do not.

Who Gets the Dependency Exemption?

Dependent children are valuable tax exemptions. Divorced, single, and married parents filing separately—including separated but not yet divorced parents—cannot both claim the same children as exemptions. IRS computers cross check parents’ returns for this kind of double dipping.

Without a written agreement to the contrary, the parent with the children the most days gets the exemption. But if the other parent furnishes over 50% of the child’s support, he is entitled to the exemption. However, he must file with his tax return IRS Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, signed by the other spouse, usually the mother. If the father claims the exemption without filing Form 8332, he may be contacted by the IRS for proof that he furnished over 50% of the support.

Child Support Collecting by the IRS

An effective child support collection device is an IRS interception of the owing parent’s tax refund.

If you owe more than $150 in child support and the other parent complains or receives welfare, the local district attorney can request that the IRS send your refund directly to the state. You should first receive an intercept notice allowing you to request a hearing. But judges will intervene only if you can show that the back support has been paid or that the tax refund is greater than you owe. Rarely will a judge listen to a delinquent parent’s claim of a desperate need for the funds.

If you are now married to someone other than the custodial parent to whom you owe support, your new spouse can attend the hearing and file a claim for her share of the tax refund as an injured spouse. The IRS cannot take her portion to satisfy a child support debt of yours. Your current spouse should file Form 8379, Injured Spouse Claim and Allocation.

If all or a part of your refund is intercepted wrongly—for example, the IRS took too much, or your current spouse’s share was taken—you may be able to get it back. File an amended tax return on Form 1040X.

States with income taxes also intercept tax refunds for child support debts. In Nebraska, for example, court clerks report all child support arrears to the state tax agency. Delinquents are mailed a notice and given a hearing. Your new spouse may have the right to file a claim to have her share withheld from what is sent to your child’s other parent.

Avoiding Liability for Your Spouse’s Dishonesty With the IRS

The “innocent spouse” rule isn’t the only way to avoid liability for your spouse’s underreporting or overdeducting to the IRS. The rules differ, depending on what state you lived in when you filed your return. These rules—including the innocent spouse rule—are briefly described below.

Community Property States (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) Non-Community 
Property States (the rest) All States
Innocent Spouse Rule:
  • You and your spouse did not file a joint income tax return.
  • You did not know and did not have reason to know of the unreported income (this means you had no knowledge of the amount of the income, and you had no knowledge of the existence of the item of income itself).
  • The income belongs solely to your spouse.
  • It would be unfair to include the unreported income in your income.
Abandoned Spouse Rule:
  • You and your spouse were married at some time during the calendar year.
  • You lived separately and apart during the entire calendar year.
  • You did not file a joint return.
  • You did not receive any portion of your spouse’s income.
Denying Benefit of Community Property Law Rule:

If your spouse acts as if he or she is solely entitled to a portion of community income and does not tell you about that income by the time your tax return is due, your spouse will be solely responsible for reporting the income. This is because even when spouses file separate returns, each must report one-half of the combined community income.

Innocent Spouse Rule:
  • There is a substantial understatement of tax from income and deductions of the other spouse.
  • You did not know and did not have reason to know of the dishonesty. This claim presents a problem because a spouse is required to read a joint return before signing it.
  • It would be unfair to hold you liable.
  • You did not receive any benefit from the unreported income.
Innocent Spouse Rule:
  • If you had no income and believed that you were not obligated to file a return, you will not be assumed to have authorized your spouse to sign your name on a joint return. You may be able to claim that your spouse forged your name to a joint return.
  • On the other hand, if you have your own income and do not file separately, the IRS will assume you intended to file jointly, and you cannot claim that your spouse forged your name to a joint return.
Duress Rule:
  • You must have been unable to resist the demands of your spouse to sign the return, and you would not have signed the return if the pressure had not been applied.
resource

For extensive information on divorce and taxes, including the innocent spouse rule, see Divorce & Money: How to Make the Best Financial Decisions During Divorce, by Violet Woodhouse with Dale Fetherling (Nolo).

Owning Property Jointly

Many people—friends, domestic partners, parents and children, siblings, lovers, and married people who file their taxes separately—own property or assets together. There are three serious tax dangers inherent in co-ownership, however.

Audit Risk. If the joint property is held for investment, an IRS auditor may challenge the co-owners’ allocation of their tax liability—how each reported annual income or losses, or the gain or loss on the sale of the asset.

Example:

Marcus bought a warehouse with his funds and his daughter, Anita’s, separate funds. He put title to the property in his name with Anita. He wanted Anita to inherit his interest in the warehouse when he died. Marcus did substantial repairs and renovations to the building, and the rents that year did not cover the expenses. Consequently, Marcus took a rental property loss on his tax return. He was audited, and the IRS held that as co-owner, he could deduct only one-half of the loss. Anita, a college student, was entitled to deduct the other half of the loss. Anita had no income, however, and so the loss was of no tax benefit to her.

Ownership Risk. If one joint owner owes the IRS, the entire property may become an IRS seizure target. For instance, the IRS can easily grab a joint bank account you hold with your mother, brother, or lover to satisfy either their tax debt or yours.

Example:

Let’s stick with Marcus and Anita and change the facts a little. Several years after Anita graduates from college, she opens a business. The business folds and she’s left owing the IRS $34,000. The IRS issues a seizure notice to take the warehouse because of Anita’s name on the deed. Marcus calls the IRS to object to the seizure. If Marcus presents evidence showing that he is the true owner—he paid the deposit and all the mortgage payments and Anita didn’t contribute anything—the IRS may hold off from seizing the property to satisfy Anita’s tax debt. (See Chapter 7 for more information on seizures, and Chapter 8 for information on contacting a taxpayer advocate.)

Death Risk. At the death of a joint owner, an IRS auditor may allocate 100% ownership to the estate of the deceased to maximize taxes on the estate.

All of the IRS assumptions in the three scenarios above can be overcome. Legal precedent allows joint owners to:

  • allocate income, losses, and deductions unequally, according to the contributions of the co-owners toward the purchase and maintenance of the property
  • keep their share of joint property away from the IRS, and
  • prove that true property ownership is not necessarily what is stated on a deed or other title document.

But to convince an auditor, appeals officer, or a tax court judge, you must provide testimony or other evidence showing that the way title is held does not reflect the property’s true ownership. If this is your situation, see a tax professional—preferably a tax lawyer.

Death and Taxes

resource

This is not a book about estate planning, but we will go over some tax basics. There is good information on the subject, including Plan Your Estate, by Denis Clifford (Nolo). You can get free information on death-related taxes from the IRS. Call 800-829-3676 and ask for Publication 448, Federal Estate and Gift Taxes, or visit the IRS’s website at www.irs.gov.

IRS problems don’t always stop at death—at least for the survivors. Past taxes can be collected from an estate or from its heirs. For instance, a few years back a drug smuggler and his plane went down with narcotics aboard. The IRS presented a tax bill to his estate for the street value of the drugs, which were subsequently destroyed by the police.

Audits begun before death or even after must be defended by your executor. She is legally responsible for paying all income or estate taxes from your assets before your heirs get anything.

If you are an heir, executor, or administrator and are concerned about taxes owed on an estate, ask a tax professional, or get IRS Publication 559, Tax Information for Survivors, Executors and Administrators.

caution

If estate taxes are due, the IRS has, by law, a tax lien on all estate assets. (Internal Revenue Code §6324.) The IRS can seize money or property from the heirs and executors if the tax isn’t paid, for up to ten years after the estate tax is determined.

Filing a Federal Estate Tax Return

If the gross value of your estate—all property you leave at death—exceeds the estate tax-exempt amount ($2 million in 2006–2008), your executor must file a federal estate tax return (Form 706). Anything over the exempt allowance for the year of death is taxed—except what is left to your spouse. (Certain other bequests are also tax free.)

If the net worth of your estate is less than the exempt amount, your estate will not be liable for federal taxes—assuming you haven’t made any taxable gifts during your lifetime. This exception means that you can’t avoid the estate tax by making large gifts—if the total given away and remaining in your estate exceeds the exemption granted in the tax code for the year that you die.

Example:

Doug died in 2006. He had a money market account of $800,000 and two houses. House One has a market value of $800,000, with $700,000 still owing on the mortgage. The market value of House Two is $500,000; the mortgage balance is $100,000.

Gross Estate Net Estate
$800,000 (money market) $800,000 (money market)
+$800,000 (first house) +$100,000 (house’s equity)
+$500,000 (first house) +$400,000 (house’s equity)
$2,100,000 (Gross Estate) $1,300,000 (Net Estate)

Because Doug’s gross estate exceeds the $2 million exempt amount, his executor must file a federal estate tax return. Doug’s estate won’t owe any federal taxes, however, because the net value of $1.3 million is less than the exemption. It may owe state death taxes, however, depending on the law in the state Doug lived in.

IRS Audits of Estate Tax Returns

The larger the estate shown on the federal estate tax return, the more likely an audit. The IRS figures that there is more incentive to cheat when a lot of money is at stake. The IRS audits about 50% of all estates valued at $5 million or more, 25% of estates from $1 million to $5 million, but less than 10% of estates valued under $1 million. The overall audit rate is 15%. While the estate tax audit rate has dropped over the past ten years, the additional tax and penalties collected has more than made up the slack.

When the IRS picks an estate tax return for audit, the auditor will automatically scrutinize the deceased taxpayer’s last two income tax returns.

see an expert

Hire a professional if the estate is over the exempt amount. The personal representative of an estate should hire a top-flight tax professional—a CPA or tax attorney—to prepare an estate tax return whenever the estate exceeds the exempt amount ($2 million in 2006–2008).

An estate tax audit is similar to an audit of an income tax return. Both require documentation and explanation of the data on the tax return. (See Chapter 3.) The legal issues are quite different from the audit of a living taxpayer—typically more complex. This is a tax professional’s territory.

In contrast to an audit of a live taxpayer, an estate tax auditor does extensive investigation before anyone is notified of the audit. He will likely go to the probate court and copy documents from the file and research legal issues such as marital property rights.

The auditor begins the examination interview by requesting documentation of common items like administration expenses, such as lawyer’s fees. Ordinarily, cancelled checks and paid bills will adequately substantiate these deductible expenses.

After covering routine matters, the auditor moves on to thornier issues, such as the value of stock in a family corporation or whether any deathbed gifts were made to cut down the size of the estate. If so, the auditor will want to know if the proper gift tax returns were filed or if the gifts were covered by the gift tax exclusion rule.

Dealing With an Estate Tax Auditor

A personal representative should not handle an estate tax audit without a top-flight tax professional. Estate return audits are usually held at the IRS offices. You or your tax professional may need to research the law or find additional documents. If the auditor wants more records, he will schedule another meeting and give you an Information Document Request at the conclusion of the day.

Estate auditors are more likely to intimidate a personal representative than an experienced tax professional. Auditors negotiate tax issues on which the facts or law are uncertain, if you know how to play the game. Estate auditors want to close out cases. (See Chapter 3, “Winning Your Audit,” for tips on negotiating with an auditor.)

If you aren’t happy with the way the estate tax audit comes out, you can appeal (see Chapter 4, “Appealing Your Audit”) or go to tax court (see Chapter 5, “Going to Tax Court”).

caution

IRS estate tax auditors are the cream of the IRS crop and are usually CPAs or lawyers. They can spot things like whether the assets listed are consistent with the deceased person’s lifestyle, business, or profession. They are always skeptical of the values of assets listed in estate tax returns.

What Estate Tax Auditors Look For

Auditors look out for certain red flags on estate tax returns. (Internal Revenue Manual § 4350.) Some hot items include the following:

  • Unrealistic valuations of estate assets. This is the single most common adjustment made by auditors. Many people are tempted to undervalue an estate asset because the estate tax is so heavy—it starts at 37%. It is easy to value bank accounts and publicly traded stocks and bonds. Family businesses, real estate, art, antiques, and other items, however, all present valuation issues for the IRS to probe.

    The personal representative of the estate should always get written professional appraisals of all large assets other than cash and listed securities. Many states mandate court-appointed appraisers for estate assets. The IRS is not bound by the state appraiser’s figures. The IRS may hire its own appraiser if a valuation is questionable or if the estate’s value is in the millions of dollars.

  • A discount of an asset’s value. Discounts from fair market value should be used by appraisers and accountants to value the interests in family LLCs, partnerships, or corporations. Discounts can be justified if they satisfy specific tax rules. For example, the fair market value of Veronica’s 40% share of a family limited partnership dry cleaning business is $180,000 when she dies. But because there are probably not many buyers for a minority interest in a small business (other than family members), a discount of 30% to $126,000 for estate tax purposes would likely pass muster.
  • Claims against the estate by heirs, for more than what they would otherwise inherit. For example, Sam’s estate tax return shows a $50,000 promissory note from Sam, the deceased parent, to Sam, Jr. Since this claim reduces the taxable estate, an auditor will want details on when and why the loan was made and to see the loan documents.

  • Property in any safe deposit boxes that may not have been shown on the tax return. The personal representative should inventory the box’s contents and attach this to the estate tax return.
  • Erroneous or incomplete estate tax returns. Expect a problem if schedules or documentation that normally accompany an estate tax return are missing. An estate tax return is longer and has more attachments than does an ordinary tax return. Have it professionally prepared to reduce IRS audit issues.
  • Any gift tax returns that were filed during the deceased’s lifetime. The auditor will compare gift tax returns with the estate tax return for consistency. For example, Malia filed a gift tax return five years prior to her death showing that she gave her daughter, Ariana, a home worth $250,000. The law requires all large lifetime gifts to be listed on the estate tax return. Also, the auditor will look for occasions when a gift tax return should have been filed but was not.

Are you the executor of an estate with heirs other than yourself and with assets worth at least the exemption amount? See an experienced CPA or tax lawyer. (See Chapter 13 for information on finding a CPA or lawyer.) Don’t take any chances—you are personally liable to the IRS, as well as to the heirs, if you understate or don’t pay all estate taxes due—including those that may be assessed on an estate tax audit. The estate should pay your professional fees for this service.

Example:

Randolph, an executor, filed a federal estate return for his deceased old friend, Gregory. He listed values of various estate assets according to a list that Gregory prepared shortly before he died.

Per Gregory’s wishes, Randolph distributed the estate’s assets to Gregory’s son, who promptly blew the money in Vegas. The IRS audited the estate tax return two years later and found the estate assets were undervalued by $200,000. The estate was hit with a tax bill of almost $100,000. “But all of the estate assets are gone,” Randolph said. “Too bad,” said the IRS. Legally, Randolph, as executor of the estate, was personally liable for the tax!

If Randolph had gotten bona fide appraisals, he could have properly prepared the tax return and defended the valuation of the assets against IRS attack.

Reduce chances of being picked for an IRS estate tax audit by attaching copies of appraisals and other documents supporting valuations to the federal estate tax return. This is the first thing the IRS looks for in deciding whether or not to audit an estate tax return.

Joint Ownership and Death

Contrary to popular belief, you cannot escape federal estate taxes through joint ownership of assets. The only exception is when the co-owners are legally married to each other. If a joint owner dies, an IRS auditor may reallocate all the ownership shares to the deceased person’s estate if the other co-owner didn’t contribute equally to acquire the asset.

This issue is a concern only for nonspouse co-owners who hold their property as joint tenants with the right of survivorship—where the survivor(s) automatically inherits the deceased person’s share.

Example:

Hilda (mother) and Gertie (daughter) jointly hold title to an apartment building free and clear with a market value of $5 million. Hilda bought the building many years ago with the proceeds of a life insurance policy she received when her husband died. Gertie made no contributions to the purchase price of the property or for its upkeep. When Gertie reached adulthood, Hilda added her name to the deed so that Gertie would inherit the building without going through probate.

After Hilda died, Gertie filed a federal estate tax return listing the building’s value at $2.5 million, thinking that only her mother’s one-half ownership portion was taxable. The IRS audited the return and properly reallocated the entire $5 million to Hilda’s estate, producing a hefty tax bill. Even though Gertie avoided probate, the joint ownership didn’t avoid the estate tax.

Chapter Highlights

  • There are special tax rules for folks related by blood or marriage.
  • Married couples filing taxes jointly should be aware of negative consequences to one spouse if there is a tax balance due.
  • Owning property jointly with another may have some hidden tax traps.
  • Death often brings estate tax issues requiring professional help.