Federal tax law provides two more methods (see previous post re Treatment of Community Income Where Spouses Live Apart) in which a spouse may escape the responsibility to report one-half of all community property income on a separately filed return. Neither of these provisions require that the spouses live apart.
The first is provided by IRC § 66(b). This section provides that if one spouse “acted as if solely entitled to such income and failed to notify the taxpayer’s spouse before the due date (including extensions) for filing the return for the taxable year in which the income was derived of the nature and amount of such income”, the item of community income is included, in its entirety, in the gross income of the spouse who received the income and that spouse is also responsible for the tax liability relating to that item of income. Whether a spouse has acted as if solely entitled to the item of income is a facts and circumstances determination. This determination focuses on whether the spouse used, or made available, the item of income for the benefit of the marital community or did not.
The final provision (IRC § 66(c)) requires that the spouse not including an item of otherwise community income on their separately filed income tax return must be able to establish “that he or she did not know of, and had no reason to know of, such item of community income, and taking into account all facts and circumstances, it is inequitable to include such item of community income in such individual’s gross income”. Again, all of the facts and circumstances are considered in determining whether a requesting spouse had reason to know of an item of community income. A spouse had knowledge or reason to know of an item of community income if he or she either actually knew of the item of community income, or if a reasonable person in similar circumstances would have known of the item of community income. The relevant facts and circumstances include, but are not limited to:
- the nature of the item of community income;
- the amount of the item of community income relative to other income items;
- the couple’s financial situation;
- the requesting spouse’s educational background and business experience; and
- whether the item of community income was reflected on prior years’ returns (e.g., investment income omitted that was regularly reported on prior years’ returns)
All of the facts and circumstances are also considered in determining whether it is inequitable to hold a spouse liable for a deficiency attributable to an item of community income. Such facts and circumstances include whether or not the spouse benefitted, directly or indirectly, from the omitted item of community income even if such benefit occurred years after the tax return was filed. Other factors may include economic hardship, health and the presence of abuse. To qualify for this provision a valid IRS Form 8857 Request for Innocent Spouse Relief must be filed. See Revenue Procedure 2013-34 for further guidance.