What are your options to effectively deal with the tax quagmire your spouse has created?
You must report one-half of the total community income—your earnings plus spouse’s earnings—for the year. Mischel v. Commissioner (1997) T.C. Memo. 1997-350. This could be more or less than your individual wages, depending on which one of you earns the most. In practice, this means that you must determine your spouse’s true income in order to file an accurate married-filing-separately return. If your spouse is a regular employee, you may be able to sneak a peek at his or her Form W-2. Of course, your spouse is less likely to cheat if he or she knows that their employer will report his or her income to the IRS anyway.
In the more likely event that your spouse is a self-employed contractor who takes cash under the table or overstates deductions, there may be no way you can accurately determine your spouse’s income. This leaves you in a classic Catch-22: your spouse’s failure to report income—the very reason you need to file separately—also makes it difficult for you to file an accurate return.
One potential solution is a marital property agreement under which you both as a couple agrees that each spouse’s earnings will be his or her separate property. This gives only prospective relief. A valid marital property agreement will generally be respected for tax purposes. Helvering v. Hickman (9th Cir. 1934) 70 F.2d 985.
Once the agreement is in place, you will have the right to receive —and be liable for the taxes on—only your own earnings. Of course, you cannot enter into a valid marital property agreement unilaterally— your spouse has to agree too. If your spouse is not interested, your choices come down to the following:
- Divorce or legal separation, in which case both spouses’ future incomes will be their separate property, or
- Filing separate returns that report one-half of the community income as accurately as possible.
There is statutory relief in the nature of innocent spouse for those filing as married filing separate under §66. You, as a spouse, will not be held responsible for one-half of your spouse’s income if you did not have reason to know of the income or benefit from it. While less than perfect, filing a separate return may be the only real choice for you if you do not want to give up on your marriage to an uncooperative spouse.
You could still be faced with an audit to determine the correct amount of community income, and may have to pay interest and accuracy penalties if you guess wrong. However, relief may be available if:
- You did not file a joint return for the taxable year in question
- The community income that you failed to report is properly allocatable to your spouse (for example, your spouse’s earnings)
- You did not know of, and had no reason to know of, the item of community income
- it would be inequitable to include the item of community income in your gross income, taking into account all of the facts and
circumstances. I.R.C. 66(c); 26 C.F.R. §1.66-4.
This can be a tall order. But by filing a separate return, at least you will have a fighting chance to minimize the cost of your spouse’s wrongdoing, and you will not commit a felony in the process.
This is just a basic overview and is not legal advice specific to your situation. If you would like to speak with me about your situation, please email me at firstname.lastname@example.org or call 925-217-3255