Tax Issues:Part 1-Income & Fraud
There is an unfortunate consequence of divorce, in that through the discovery or disclosure process, often new sets of eyes on the financial data provided reveals tax liabilities, tax fraud, tax crimes, or other tax cheats that have occurred (often for many years).
For many divorcing parties, taxes are not top of mind during divorce. The divorce landscape concerns asset division, child custody, child support, spousal support, and disposition of the marital home. With all of these issues to juggle, the issue of taxes seems like a less important concern.
But gross income earned during the marriage is central to spousal and child support issues and plays a significant role in the divorce process. There is a need for accurate income and marital assets disclosure for divorce purposes. If income is underreported on taxes, this could have a major impact on the support obligations and consequently the fairness of the support awards.
The income reported on tax returns is presumptively correct for divorce purposes, but rebuttable with evidence to the contrary. This is where an informed CDFA@ professional can be helpful in determining if there has been underreporting of income on the return and uncovering the actual income. This tends to surface as an issue with the ownership of rental properties and/or with closely held businesses, family businesses, or professional practices.
Aside from the impact of gross income underreporting on tax returns, failure to consider other tax issues may result in fines, penalties, outstanding tax bills, or even worse consequences for both parties.
This is especially prevalent when one spouse takes care of all the finances of a marriage and the other spouse is unaware of what is occurring. Problems with unpaid taxes can be a huge issue for the unknowing spouse who will be equally responsible in the eyes of the IRS for any penalties and interest that may be due. Often, the spouse who trusts the other and blindly signs the joint tax return may be in for a rude awakening during the pendency of divorce. Others who are threatened by an abusive spouse and not allowed to question or even review the return are equally culpable, unfortunately.
Even with the “innocent spouse” IRS rule, many spouses are not granted relief for unpaid taxes if this was not applied for within the statutory constraints of the tax law. There is a two-year deadline that once can file for this consideration. While this is particularly unfair in domestic abuse situations, there does not seem to be any relief despite the valiant attempts at procuring such by lawmakers, IRS taxpayer advocates, legal aid attorneys and the like.
Obtaining Innocent Spouse relief is difficult. Even if a spouse files within the two-year allowed period, the IRS has a track record of granting relief to less than half of the 50,000 innocent spouse relief claims received each year. While many denials are due to missing the two-year deadline, the greater issue is that burden of proof that is placed on the spouse that they did not know or had no reason to know that their spouse was not paying or underpaying their taxes.
A spouse may want to become an informant spouse and spark an investigation/tax crime prosecution. But while this may initially sound very attractive, it could have unintended consequences.
There is a potential for a huge depletion of the marital assets to satisfy the tax evasion or fraud and an unlimited statute of limitation if it is tax fraud. The IRS may go back as many years as necessary in order to make an example of the fraudster.
Furthermore, there is the potential for a decrease or even cessation of the continuing income stream of the accused spouse while the investigation is underway and potentially long afterward. If the spouse has a professional license, it would be in jeopardy of being retracted.
The supposedly “innocent spouse” may not get a pass on the prosecution. Tax fraud is a criminal offense and the spouse may also be brought into the fold as a co-conspirator.
The IRS will also reject claims if the spouse benefitted from the tax avoidance. Often, during divorce, the spouse who turned a blind eye to the tax evasion, avoidance, fraud or underreporting may now feel that they are on the other side of the situation and would like to score retribution to the fraudulent taxpayer spouse. However, this is not a very wise decision to make because the spouse is likely to be found just as culpable as the taxpayer who initiated the problems. It is quite likely that both spouses benefitted during this time and the burden of proof is very high to overcome the allegation that the other spouse was unaware of their lifestyle made possible by paying lower or no taxes.
Divorce does not relieve a spouse from liability for a joint tax return while you were married for taxes that may have gone unfiled or for unpaid taxes. Good divorce attorneys will often include a provision in the settlement to indemnify a spouse who truly did not know of the tax issues. The IRS may not give any indemnification and will completely disregard any settlement agreement or even court order pursuant to divorce.
However, while the spouse may be liable to the IRS, the settlement agreement may still indemnify that spouse by requiring that any payment the spouse must make must be reimbursed to that spouse. This could mean that the taxpayer who knowingly committed fraud may be obligated to obtain a loan or forfeit an asset awarded during the divorce to the spouse to make them “whole” from having to pay for taxes, penalties and/or interest.
While divorce is overwhelming as it is with unwinding the marital finances and planning for co-parenting and support for the children of the marriage, tax considerations of tax behavior during the marriage are significant to demand attention by financial and legal professionals involved in the dissolution as part of their fiduciary duty to the spouse who retains them.
This article does NOT constitute tax or legal advice and is for general information purposes ONLY. Prior to making any decisions, seek legal counsel from a licensed attorney and CPA.
