Proving lack of knowledge for IRS Innocent Spouse Relief can be challenging
In most tax matters, such as tax fraud prosecutions, the IRS has the burden of proof. So, these matters are inherently difficult for the Service to prove. But in innocent spouse proceedings, the claimant has the burden of proof to establish innocence, which is why the innocent spouse rule’s knowledge requirement is such a stumbling block in many of these cases.
As used in IRS Publication 971, “actual knowledge or reason to know” is more like willfull blindness. Framing the innocent spouse rule’s knowledge requirement in these terms may help us better understand what facts are relevant and what claimants need to prove.
Elements of the Innocent Spouse Rule’s Knowledge Requirement
Since the claimant has the burden of proof in these instances, there is a presumption that none of the elements are present, and the claimant must produce sufficient evidence on each point to convince a Tax Court judge that there is sufficient evidence.
Actual knowledge, which means just what it says it means, is almost impossible to establish, unless there is a smoking gun email or some other such proof. So, most cases turn on the alternative requirement, which is a “reasonable person in similar circumstances would have known” that the portion of the tax return was erroneous. Such a dispute normally involves either unreported income or an exaggerated deduction. To make this determination, the IRS looks at “all facts and circumstances,” including:
- Nature of the Disputed Item: Some items are glaring, like a child tax credit for a child that’s not in day care. Other items are more subtle, such as business expenses for a separate entity. This factor assumes that the claimant knows something about taxes in general, and the couple’s return in particular.
- Recurring Pattern: If the return declared business income for 2010 through 2015 and that income suddenly disappeared in 2016, there is a presumption of willfull blindness. Once again, this factor assumes that the claimant had meaningful input into the couple’s return.
- Financial Situation: This factor is not related to knowledge of the tax return, but it does require claimants to put two and two together, and that’s not always as easy as it sounds. Nevertheless, if a couple barely made ends meet in 2015 and took monthlong French Riviera vacations in 2016, the IRS may presume knowledge.
- Educational Background: This element may be the most controversial one in the innocent spouse rule’s knowledge requirement, because many advocates believe that it punishes claimants (who are mostly women) for being well-educated and having some financial knowledge. Essentially, if the claimant felt that something was amiss with the return, the claimant had a duty to ask questions.
Other factors include the extent of the claimant’s participation (e.g. using his/her own money to set up a fake company).
How It Works
One of the most noteworthy recent cases on the innocent spouse rule’s knowledge requirement is 2012’s Young v. Commisioner. The IRS claimed that Mr. Young overstated his business expenses by some $125,000 over several years. Ms. Young, who was a licensed realtor and also had a real estate degree from the University of Miami, was not working at the time. At first blush, based on factors like her educational background, the couple’s financial situation, and the recurring nature of the understatement, Ms. Young’s claim for innocent spouse relief seemed like a long shot.
Nevertheless, the court concluded that the evidence was insufficient to prove knowledge, because “[k]nowledge of and involvement in an activity, by itself, is insufficient to demonstrate actual knowledge of the circumstances leading
to the disallowance of the item on the return.” The court also repeatedly noted that Ms. Young did not have any “day-to-day” involvement with the business.
Based on Young, absent discussions of specific items and meaningful participation in financial activities, it is much easier for claimants to prove lack of knowledge by a preponderance of the evidence.