Taxpayers who contact the clinic may have a number of tax issues. The most common issues are related to claims for head of household filing status, earned income tax credit, child tax credit and dependency exemptions. Brief overviews of these substantive issues are provided.
Affordable Care Act
A taxpayer will be exempt from the financial penalty if he/she qualifies for one of the following nineteen exemptions:
- Coverage is considered unaffordable (more than 8 percent of your actual household income for the year as computed on your tax return)
- There was a gap in coverage for less than three consecutive months during the year
- Income for the year is less than the minimum threshold for filing a tax return
- S. Citizens or residents who fall into one of the following categories even if you have a social security number: (1) U.S. citizen or resident spent at least 330 full days outside the U.S. during the 12-month period, (2) U.S. citizen was a bona fide resident of a foreign country or U.S. territory, or (3) Resident alien who was a citizen of a foreign country with which the U.S. has an income tax treaty with a nondiscrimination clause, and was a bona fide resident of a foreign country for the tax year
- Member of a health care sharing ministry (organization described in section 501(c)(3) whose members share a common set of ethical or religious beliefs and have shared medical expenses in accordance with those beliefs continuously since at least December 31, 1999)
- Member of Federally-recognized Indian tribe
- Incarceration (after the disposition of charges)
- Member of a religious sect in existence since December 31, 1950 that is recognized by the Social Security Administration as opposed to accepting insurance benefits
- Two or more family members’ aggregate cost of self-only employer-sponsored coverage exceeds 8 percent of the household income, as does the cost of any available employer-sponsored coverage for the entire family
- Gap in coverage at the beginning of 2014 but you (1) enrolled in coverage through the federally-facilitated Marketplace by March 31, 2014, (2) enrolled in coverage through a state-based Marketplace by March 31, 2014, or (3) enrolled in coverage outside the Marketplace with an effective date on or before May 1, 2014.
- Experienced circumstances such as homelessness, eviction, foreclosure, domestic violence, death of a close family member, and unpaid medical bills
- Coverage considered unaffordable based on your projected household income
- Ineligible for Medicaid solely because you live in a state that does not participate in Medicaid expansion under the Affordable Care Act
- Reside in a state that did not expand Medicaid and your household income is below 138 percent of the federal poverty line for your family size
- Unable to renew existing coverage because of notification that your health insurance policy was not renewable and other plans available are unaffordable
- Applied for CHIP coverage during the initial open enrollment period and were found eligible for CHIP based on that application but had a coverage gap at the beginning of 2014
- Engaged in service in the AmeriCorps State and National, VISTA, or NCCC programs and are covered by short-term duration coverage or self-funded coverage provided by these programs
- Enrolled in certain types of Medicaid and TRICARE programs that are not minimum essential coverage (only in 2014)
- Were eligible, but did not purchase coverage under an employer plan with a plan year that started in 2013 and ended in 2014 (only in 2014)
The IRS administers the penalty provisions that are imposed on taxpayers who do not purchase insurance, the penalties for purchasing too expensive a policy (called a Cadillac Policy), and with sending the monthly subsidies. If a taxpayer pays more in medical insurance premiums than the subsidy that is received, the taxpayer may be entitled to a refund. If the opposite occurs, the taxpayer may have to repay the IRS the difference. The taxpayer is required to submit Form 1092-A from the insurance provider, along with IRS Form 8962 (Premium Tax Credit), and reconcile the amount paid and the amount received.
Internal Revenue Code
- IRC §71 Alimony and Separate Maintenance Payments
- IRC §215 Alimony, etc., Payments
- Treas. Reg. §1.71-1T Alimony and separate maintenance payments (temporary)
IRS Forms and Publications
- Form 1040 U.S. Individual Income Tax Return
- Publication 504 Divorced or Separated Individuals
- Tax Topic 406 Alimony Received
- Ga. Code Ann. § 19-6-1 (2004) Alimony defined
Georgia Case Law
Distinguishing periodic alimony from lump-sum alimony:
- Winokur v. Winokur, 365 S.E.2d 94, 95 (Ga. 1988)
- Dolvin v. Dolvin, 284 S.E.2d 254 (Ga. 1981)
- Davenport v. Davenport, 255 S.E.2d 695 (Ga. 1979)
Defining temporary alimony:
- Chatsworth Lumber Co. v. White, 107 S.E.2d 827, 828 (Ga. 1971)
- Butler v. Hicks, 189 S.E.2d 416, 419 (Ga. 1972)
Federal Case Law
Distinguishing periodic alimony from lump-sum alimony:
- Human v. Commissioner, T.C.M. 1998-65
- Hopkinson v. Commissioner, T.C.M. 1999-154
Defining temporary alimony:
- Stokes v. Commissioner, T.C.M. 1994-456
The taxpayer should correct his return that is already filed if he finds that:
- He did not report some income;
- He claimed deductions or credits he should not have claimed;
- He did not claim deductions or credits he could have claimed; or
- He should have elected a different filing status.
Documents on IRS.gov
Business Expense Deductions
The IRS occasionally questions whether the taxpayer is conducting a business claiming that the taxpayer instead is engaged in a “hobby.” If this is proved, deductions may be disallowed under § 183. This occurs generally when there is no documenting information sent to the IRS supporting the income such as a Form 1099 . The student attorney should work with the client to substantiate the business activity and the claimed expenses. The student attorney should also review the applicable law or speak with a supervisor to ensure that the deduction is proper and that the client was engaged in a business.
The student attorney should exercise due diligence before submitting a claim for business deductions. The IRS is concerned that a taxpayer may exaggerate business losses to offset income from other sources (such as the wages of a spouse). The reduction in reported income may increase the size of tax credits such as the Earned Income Tax Credit (EITC).
Deductions under IRC § 162 (arising from a trade or business) are distinct from § 212 (arising from the production of income such as an investment activity).
To substantiate claimed business expense deductions, the student attorney will prepare a notebook for the IRS. The notebook should include:
- A copy of any correspondence from the IRS, especially notices explaining changes to the return
- A copy or transcript of the tax return
- A memorandum
- Exhibits to substantiate the claimed expenses
- A mileage log or odometer readings
- Calendar of daily business activities
- Profit/Loss statements
- Bank statements indicating business income
- Receipts for expenses
- Customer rosters
A sample memorandum is available below. A good example of a Tax Court discussion of business expense deductions contained in Delima v. Commissioner, T.C. Memo. 2012-291 (October 16, 2012) (linked below).
While the specific rules for deductions vary depending on the type of expense, here are four things to keep in mind:
- The expense must be connected with a business (discussed below);
- The expense must be both commonly incurred in the type of business in which the taxpayer is engaged and appropriate and helpful in that business;
- The expense must be paid;
- Generally, the expense must be substantiated with documentary evidence.
The IRS may challenge the existence of a business. A business must have the opportunity for profit, and not be merely a source of deductions used to offset other income. IRC § 183(a). The IRS will presume that an activity is not a business if the client reports losses from the activity for three out of five years. IRC § 183(d). This presumption can be rebutted with evidence that the client had a bona fide belief that her activity would produce a profit, and the student attorney should seek evidence of this belief (e.g., the client had no other source of income, had prior success, etc.).
If the client is unable to establish that a business exists, under limited circumstances the client may still deduct expenses up to the amount of income from the activity. IRC § 183(b)(2). This is normally presented as an alternative argument for claiming the deductions.
The IRS may also disallow a deduction for expenses even though a business exists. Often, these disallowances arise because the IRS believes the expense is personal in nature (especially clothing, meals, or travel to popular vacation spots).
The IRS usually requests substantiation of claimed expenses. IRC § 274(d). In these cases, the student attorney should work with the client to gather documentary evidence. Help the client create a system for organizing documents, but have the client sort through receipts. You may want to prepare a spreadsheet on which the client can insert the claimed expenses and supporting evidence The spreadsheet may become an Appendix for the notebook. A client may no longer have their business records. There are limited circumstances when the taxpayer is allowed to reconstruct the records. If this issue arises, first discuss the situation with your supervisor.
In certain cases, the IRS may challenge the existence of business income reported on the client’s return but that was not reported on a Form 1099. Taxpayers with very low income, especially those with children, may benefit from higher income which increases the EITC. Any self-employment tax due on the non-existent income will be offset by the increased credit. In these cases, the IRS may request bank statements or business records indicating receipt of the reported income. If these records are not available (and it is not unreasonable for a very small business to operate on an entirely cash basis; e.g., informal childcare, day labor, etc.), the student attorney should ask the client to collect signed statements from customers attesting to the business and the value of any payments to the client.
Child Tax Credit
A taxpayer with a qualifying child may take a credit of up to $1,000.00 for each qualifying child. Also, if the amount of the credit is greater than the amount of tax owed, an “additional child tax credit” may be claimed.
Rules and Requirements
To qualify for the child tax credit:
- Taxpayer must have a “qualifying child”; and
- Taxpayer’s modified adjusted gross income must be below a certain amount. The amount at which the credit phase-out begins varies depending on the taxpayer’s filing status:
- Married Filing Jointly – $110,000
- Married Filing Separately – $55,000
- All others- $75,000
For years after 2004, there is a uniform definition of a “qualifying child”. MAGI amounts change each year, so consult Publication 17 for the applicable year for further guidance.
The taxpayer’s qualifying child must be:
- Under the age of 17 at the end of the tax year
- A U.S. citizen, U.S. resident or U.S. national.
- Claimed as taxpayer’s dependent
- The taxpayer’s:
- Son or daughter
- Stepson or Stepdaughter
- Adopted child – includes a child placed with taxpayer for adoption by an authorized placement agency, even if the adoption is not final. An authorized placement agency includes any person authorized by state law to place children for legal adoption.
- Grandchild – any descendant of taxpayer’s son, daughter, or adopted child. A grandchild includes taxpayer’s great-grandchild, great-great-grandchild, etc.
- Eligible foster child:
- Child must have lived with the taxpayer as a member of the taxpayer’s household for the whole year,
- Taxpayer must have cared for that child as her own, and
- Child is taxpayer’s brother, sister, stepbrother, or stepsister; a descendant (including a child or adopted child) of taxpayer’s brother, sister, stepbrother, or stepsister; or a child” placed with taxpayer by an authorized placement agency. This requirement was not included until 2000.
- Brother or sister
- Step-brother or step-sister
- descendant of any of above individuals, which includes grandchild, niece or nephew
- Not have provided more than half of this/her own support.
- Single or not joining in a joint return.
- A member of taxpayer’s household for more than half of the year.
Internal Revenue Code
- IRC §24: Child Tax Credit
IRS Publications and Forms
- IRS Publication 972: Child Tax Credit
A summary of the five tests for claiming a dependency exemption appears below. The entire text of IRC §152 should be carefully read when dealing with this issue because there are numerous special rules under each of the five tests that may apply to the client’s situation.
Member of Household or Relationship Test
The first test is the member of household or relationship test. An individual must either be related to the taxpayer or be a member of the taxpayer’s household for the entire year. IRC §152(d).
An individual is related to the taxpayer if the individual is the taxpayer’s:
- Son or daughter, grandchild, stepchild, or adopted child;
- Brother or sister;
- Brother or sister by the half-blood;
- Stepbrother or stepsister;
- Mother or father, ancestor of either;
- Stepfather or stepmother;
- Son or daughter of taxpayer’s brother or sister;
- Brother or sister of taxpayer’s father or mother;
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law (the widow of a taxpayer’s deceased wife’s brother is not considered a sister-in-law); or
If the parents of a child may claim the child as a dependent but neither parent so claims the child, such child may be claimed as an dependent of another taxpayer but only if the adjusted gross income of such taxpayer is higher than the highest adjusted gross income of any parent of the child.
- A person is considered to live with the taxpayer for the entire year even if either the taxpayer or the person are temporarily absent due to special circumstances,
- Temporary absences due to special circumstances include absences because of illness, education, business, vacation, or military service,
- An absence is considered temporary if, for example, the person is placed in a nursing home for an indefinite period of time to receive constant medical care.
Death or Birth of a Dependent
- A person who died during the year, but was a member of taxpayer’s household until death, will meet the member of household test,
- The same is true for a child who was born during the year and was a member of taxpayer’s household for the remainder of the year,
- As long as the taxpayer’s child was born alive during the year, the residency test will be satisfied even if the child lived only for a moment,
- Taxpayer cannot claim an exemption for a stillborn child.
Violation of Local Law
A person does not meet the member of household test if at any time during the tax year the relationship between the taxpayer and that person violates local law.
A “child” includes:
- Son, stepson, daughter, stepdaughter, a legally adopted child, or a child who was placed with taxpayer by an authorized placement agency for taxpayer’s legal adoption,
- A foster child who was a member of taxpayer’s household for the entire tax year is also considered his child.
- A custodial parent will be the one with whom a child lives for the most number of nights in a calendar year for purposes of determining who can claim the child as a dependent when the parents are divorced, separated, or live apart. Proposed rule REG-149856-03,
- If a child is temporarily absent from a parent’s home for a night, the child is treated as living with the parent with whom the child would have lived for the night,
- Tie Breaker Rule – in the event of a tie where the child lives with each parent and equal number of nights, the parent with the higher adjusted gross income is treated as the custodial parent,
- Release to Claim Exemption – the custodial parent may release the claim to an exemption for a single year, multiple years, or all future years. The declaration must include an unconditional statement that the custodial parent will not claim the child as a dependent for the specified year or years,
- Right to Revoke – a custodial parent who released the right to claim a child by providing written notice of the revocation to the other parent.
A child must be, during some part of each of any five calendar months during the calendar year:
- A full-time student at a school that has a regular teaching staff, course of study, and regular student body,
- A student taking a full-time, on-farm training course given by a school described in (i), or a state, county, or local government.
The five calendar months do not have to be consecutive. A student who is enrolled for the number of hours or courses the school considers to be full-time attendance. A school can be an elementary school, junior or senior high school, college, university, or technical, trade, or mechanical school. However, on-the-job training courses, correspondence schools, and night schools do not count as schools for the EIC. Students who work in co-op jobs in private industry as a part of a school’s regular course of classroom and practical training are considered full-time students. Child is not a full-time student if he or she attends school only at night. However, full-time attendance at a school may include some attendance at night as part of a full-time course of study.
The second of the five tests is the support test. This test requires that the dependent not have provided over one-half of his or her own support during the year. IRC §152(c)(1)(D). For this purpose, 183 days is considered more than half the year. Worksheet 3-1 in Publication 17 can be used to determine whether this support test is satisfied.
Multiple Support Agreements
- Parents who have divorced may enter into a Multiple Support Agreement. IRC §152(d)(3),
- Each of the four requirements associated with a multiple support agreement must be met,
- No one person contributed over one-half of the support,
- Over one-half of the support was received from 2 or more persons each of whom, but for the fact that any such person alone did not contribute over one-half of the support, would have been entitled to claim the individual as a dependent for the taxable year,
- The taxpayer claiming the dependency exemption contributed more than 10 percent of the support, and
- Each member of the group who contributed more than 10 percent of support (except the taxpayer claiming the exemption) files a written declaration on Form 2120 that he will not claim the individual as his dependent for the tax year.
The members of the group may, for example, take turns at claiming the deduction. But if more than one-half of a dependent’s support is furnished by one individual, that individual is the only one who can claim the dependency deduction.
A taxpayer paying part of the support for a group of individuals would be denied any dependency deduction unless he furnished more than one-half of the support for the entire group, or unless he could prove that his contributions were directly allowable to one or more members of the group. He could not, for example, claim two of five persons as dependents just because he furnished 40 percent of the support for the group.
Gross Income Test
The third test is the gross income test. The dependent must not have had gross income in excess of the exemption amount for the year involved (does not apply if person is taxpayer’s child who is under 19 or is a student under 24.) IRC §152(c)(1)(A).
Gross Income Defined
For purposes of the gross income test, all income in the form of money, property, and services that is not exempt from tax is gross income. This includes the following:
- Total net sales minus the cost of goods sold, plus any miscellaneous income from the business,
- Gross receipts from rental property,
- A partner’s share of the gross, not a share of the net, partnership income,
- All unemployment compensation and certain scholarship and fellowship grants. Scholarships received by degree candidates that are used for tuition, fees, supplies, books and equipment required for particular courses are not included in gross income.
Joint Return Test
The fourth test is the joint return test. No dependency exemption is allowed if the dependent is married and files a joint return with his or her spouse IRC §151(c)(2).
Citizenship or Resident Test
The fifth test is the citizenship or residency test. The dependent must be a citizen, national, or resident of the United States, a resident of Canada or Mexico at some time during the calendar year in which the tax year of the taxpayer begins, or an alien child adopted by and living with a U.S. citizen or national as a member of his household for the entire tax year.
Documents to Support a Dependency Exemption Claim
These should all be copies and not originals. Never send originals to the IRS and return all originals to client after copying.
Dependents Who Live With Taxpayer:
The evidence that will support a dependency exemption claim for an individual who lives with the taxpayer are as follows:
- List of person(s) who lived in taxpayer’s household during the tax year. Include name, relationship, social security number and the number of months or days each person lived in household during the tax year,
- Copy of dependent’s birth certificate or green card if not US citizen,
- Copy of the Social Security card for dependents 1 year of age or older
Note for Puerto Rico Birth Certificates. In order to protect against identity theft, the Government of Puerto Rico enacted a new law (Law 191 of 2009 as amended) that provides for the issuance of security-enhanced birth certificates beginning July 1, 2010, and invalidates Puerto Rican birth certificates issued prior to that date. Consequently, the Internal Revenue Service will no longer accept birth certificates issued by the Government of Puerto Rico prior to July 1, 2010, as proof of age, relationship, or identity. The new information appears as the second “Note” in the table. A taxpayer who submits a Puerto Rican birth certificate issued prior to July 1, 2010, will be informed of the new law and directed to contact the Puerto Rico Vital Statistics Record Office to obtain a new birth certificate.
- School records or transcripts containing the dependent’s name, address and dates of attendance for the tax year, if the dependent was a full-time student over 18 and under age 24,
- Statement from the government agency verifying the amount and type of benefits taxpayer and/or taxpayer’s dependent received for the tax year, if taxpayer received any government benefits,
- Official letter or document stating that the dependent is disabled, if dependent was over 18 on December 31 of tax year and permanently and totally disabled,
- Copy of lease/rental agreement or taxpayer’s last mortgage statement for the year (If the taxpayer has a PO Box as the address, a copy of Postal form 1093 can be requested from the Post Office to obtain geographical address),
- Copies of utility bills (water, electricity, telephone, cable) for the tax year,
- Copies of cancelled checks/receipts for rent/mortgage payments and household expenses paid during the tax year,
- Evidence showing taxpayer lived at the same address as dependent if not related as listed above: w-2’s, utility statements, bank account statements, etc.
- Copy of the dependent’s income tax return if one was filed,
- Copy of taxpayer’s divorce decree or separate maintenance agreement, if taxpayer was divorced or legally separated from the dependent’s other parent, and any written agreement showing which parent will have custody and/or claim the dependency exemption.
For individuals who are claimed as dependents and who do not live with the taxpayer, the following evidence should be gathered:
- A computation of the total cost of the dependent’s support including the amount of income or other funds received by or for the dependent. Show how these funds were used and the amounts contributed to household expenses by each person living in the household with the dependent,
- The name, address, and phone number of any person or agency (including but not limited to Social Security Adm., Social Services, Veterans Adm.,) that provided funds for the dependent’s support and a statement from the person or agency, showing the amount provided,
- Cancelled checks and receipts to verify amounts taxpayer spent for the dependent’s support, if the dependent did not live with him. If possible, provide a signed statement from each person with whom the dependent lived, confirming that the person did not claim an exemption for the dependent and that taxpayer furnished more than half of the dependent’s total support
- A copy of taxpayer’s divorce decree or separate maintenance agreement, if taxpayer was divorced or legally separated from the dependent’s other parent, and any written agreement stating which parent will have custody and/or claim the dependency exemption
- For Tax Year 1985 and later, a Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, or similar statement, signed by the custodial parent agreeing not to claim an exemption for the child, or similar statement or copy of the following pages from the decree or agreement is attached instead of Form 8332:
- Cover page (with the other parent’s social security number)
- The page that states the non-custodial parent can claim the child as a dependent, and
- Signature page showing the date of the agreement
- Copy of the Social Security card for dependents 1 year of age or older
- Copy of dependent birth certificate or green card if not US citizen
Internal Revenue Code
- IRC §151 Allowance of deductions for personal exemptions
- IRC §152 Dependent defined
- Treas. Reg. §1.151-1 Deductions for personal exemptions
- Treas. Reg. §1.151-2 Additional exemptions for dependents
- Treas. Reg. §1.151-3 Definitions
- Treas. Reg. §1.151-4 Amount of deduction for each exemption under §151
- Treas. Reg. §1.152-1 General definition of a dependent
- Treas. Reg. §1.152-2 Rules relating to general definition of dependent
- Treas. Reg. §l.152-3 Multiple Support Agreements
- Treas. Reg. §1.152-4 Support test in case of child of divorced or separated parents
IRS Forms and Publications
Cancellation of Indebtedness
If an individual or business borrows money from a creditor (i.e. mortgage lenders, credit card companies, etc.) this does not give rise to any income tax liability because the individual or business has an obligation to repay that money. If the debt is then forgiven or cancelled, this taxpayer then has incurred cancellation of indebtedness income because their obligation to repay that money has been removed.
The failure of a lender to pursue payment does not automatically constitute forgiveness of indebtedness. When a lender cancels any indebtedness, I.R.C. § 6050 requires the lender to issue Form 1099-C and submit to the IRS and the taxpayer if the indebtedness is greater than $600. Treas. Reg. § 1.6050P-1 provides additional detail about when the debt is considered to be discharged, which indicates when the 1099-C should be issued. The mere receipt of a 1099-C by the taxpayer does not mean that they have recognized income. The lender could have issued an erroneous 1099-C or a statutory exclusion could apply to remove the cancellation if indebtedness income from the taxpayer’s gross income.
Rules and Requirements
Cancellation of Indebtedness
I.R.C. § 61(a):
“…gross income means all income from whatever source derived, including (but not limited to) the following items:
… (12) Income from discharge of indebtedness”
Treasury Regulation § 1.61-12 “Income from discharge of indebtedness”
(a) The discharge of indebtedness, in whole or in part, may result in the realization of income.
Where indebtedness is being discharged, the resulting income would equal the difference between the amount due on the obligation and the amount paid, if any, for the discharge. Martin v. Commissioner of Internal Revenue, T.C. Summ.Op 2009-121, 2009 WL 2381577 (U.S. Tax Ct. 2009).
I.R.C. § 108(a). Exclusion from Gross Income.
Gross income does not include any amount which would be included in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if:
- the discharge occurs in a title 11 case
- the discharge occurs when the taxpayer is insolvent
- the indebtedness discharged is qualified farm indebtedness
- in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
- the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2010.
I.R.C. § 108(d)(1) defines “Indebtedness of taxpayer:”
For purposes of this section, the term ‘indebtedness of the taxpayer’ means any indebtedness:
- for which the taxpayer is liable, or
- subject to which the taxpayer holds property.
Revenue Procedure 2015-57 provides that when education loans are forgiven due to the closing of a school, the borrower will not recognize COD income. The Revenue Procedure states tht the The Department of Education should no longer issue a 1099 COD for these student loans. Thus, if a client receives a 1099 COD for a student loan relating to a closed school as defined in the Revenue Procedure, the Revenue Procedure should be cited as authority for exclusion of the COD income. See the linked Revenue Procedure and IRS’s announcement below.
Insolvency, I.R.C. § 108(a)(1)(B)
I.R.C. § 108(a)(3) insolvency exclusion limited to amount of insolvency.
In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.
I.R.C. § 108(d)(e) defines “insolvent”:
For purposes of this section, the term ‘insolvent’ means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before discharge.
Bankruptcy Exclusion, I.R.C. §108(a)(1)(A)
I.R.C. § 108(d)(2):
The term “title 11 case” means a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.
A discharge that occurs in either a Chapter 7 or Chapter 13 bankruptcy is excluded from a taxpayer’s income. Proof that the indebtedness was actually discharged in the bankruptcy is required. Student attorneys should obtain a copy of the taxpayer’s bankruptcy schedules, and verify on the taxpayer’s PACER report that the bankruptcy discharge actually occurred.
Qualified Principal Residence Indebtedness, I.R.C. § 108(a)(1)(E)
I.R.C. § 108(h):
(h) Special rules relating to qualified principal residence indebtedness:
- (1) Basis Reduction
- The amount excluded from gross income by reason of subsection (a)(1)(E) shall be applied to reduce (but not below zero) the basis of the principal residence of the taxpayer.
- (2) Qualified principal residence indebtedness
- For purposes of this section, the term “qualified principal residence indebtedness” means acquisition indebtedness (within the meaning of section 163(h)(3)(B), applied by substituting “$2,000,000 ($1,000,000” for “$1,000,000 ($500,000” in clause (ii) thereof) with respect to the principal residence of the taxpayer.
- (3) Exception for certain discharges not related to taxpayer’s financial condition.
- Subsection (a)(1)(E) shall not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.
- (4) Ordering rule
- If any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, subsection (a)(1)(E) shall apply only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.
- (5) Principal residence
- For purposes of this subsection, the term “principal residence” has the same meaning as when used in section 121.
(B) Acquisition indebtedness
- (i) In general the term “acquisition indebtedness” means any indebtedness which
- (I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and
- (II) is secured by such residence.
Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.
- (ii) $1,000,000 limitation. The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).
Summary from Publication 4681 (p. 6):
You can exclude canceled debt from income if it is qualified principal residence indebtedness. Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home. Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home, but only up to the amount of the old mortgage principal just before the refinancing. . . .
To show that all or part of your canceled debt is excluded from income because it is qualified principal residence indebtedness, attach Form 982 to your federal income tax return and check the
box on line 1e. On line 2 of Form 982, include the amount of canceled qualified principal residence indebtedness, but not more than the amount of the exclusion limit . . . . If you continue to own your home after a cancellation of qualified principal residence indebtedness, you must reduce your basis in the home. . . .
Making Your Case
The most important aspect of any cancellation of indebtedness case is to gather accurate facts of the taxpayer’s case. Student attorneys should determine whether any debt has been cancelled and whether the taxpayer was insolvent immediately prior to any cancellation. Clinic investigative tools such as Accurint, GSCCA, and P.A.C.E.R. should be utilized. The taxpayer should be thoroughly interviewed about the indebtedness, and the creditor should be contacted. Some items to consider during your investigation are:
- How much did the taxpayer owe at the time of cancellation?
- Is the loan secured to property?
- If the loan is securitized, what happened with that property? Was it foreclosed on or abandoned?
- What was the value of that property at the time of cancellation?
- What year was the loan cancelled?
After a sufficient factual basis has been developed by the student attorney, as many defenses as possible to the cancellation of indebtedness income should be prepared. Some of the successful defenses used by other student attorneys are summarized below.
Disputing the sufficiency of the 1099-C
Many 1099-Cs issued by lenders have contained incorrect information or have left off necessary information. When the cancellation of indebtedness income arises from a car loan, a mortgage, or any other securitized debt, the lender must report the fair market value used to make their calculations on either the 1099-C, or a 1099-A. Student attorneys have been successful in challenging the fair market value listed by the lender.
Student attorneys should always contact the lender and try to get as much information as possible from the lender about why they reported the figures they did. Sometimes lenders will be nonresponsive, or not have records, and this circumstantial evidence can be used in making the taxpayer’s case.
In general, the IRS’s determination in a notice of deficiency is presumed correct, and the burden is on the taxpayer to prove otherwise. Tax Court Rule 142; Welch v. Helvering, 290 U.S. 111, 11 (1933). However, under certain circumstances the burden may shift where a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the income tax liability of the taxpayer. IRC § 7491(a)(1). Additionally, IRC § 6201(d) provides that in any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return, such as a Form 1099-C, and the taxpayer has fully cooperated with the IRS, the IRS has the burden of producing reasonable and probative information concerning the deficiency in addition to the information on the information return.
In Martin v. Commissioner a taxpayer disputed the fair market value of a repossessed vehicle reported by the lender on its 1099-C. The taxpayer testified in court that the value was incorrect because the fair market value of the vehicle was higher at the time of repossession, which occurred three years before the issuance of the 1099-C. The burden to prove the sufficiency of the 1099-C then shifted to the IRS, and they subsequently were unable to disprove the taxpayer’s testimony. Martin v. Commissioner of Internal Revenue, T.C. Summ.Op 2009-121, 2009 WL 2381577 (U.S. Tax Ct. 2009).
This case is illustrative of a defense that can be used by student attorneys in the Clinic. If a student attorney can assert a reasonable dispute to the fair market value listed on the lender’s 1099-C or 1099-A, then the burden will shift to the IRS to prove the 1099 is correct. If the IRS cannot prove this figure is correct, or dispute the taxpayer’s claims, the taxpayer will likely win their argument.
Real Property Valuations
Foreclosure deeds (which can be found on GSCCA), county property tax assessment values (found on Accurint or the County’s website), and comparable property sales all can be used to dispute the fair market value assigned to real property by a lender. What a vehicle was worth in a certain year, or its historical value, can be established with a service on Edmunds.com (http://support.edmunds.com/faq-Historical-True-Market-Value-TMV-499.aspx).
If the foreclosure sales price differs from the amount reported by the lender, one could argue that the foreclosure sales price is the correct fair market value because it represents what a buyer is willing to pay in the marketplace.
Treasury Regulation § 1.166-6(b) addresses the fair market value for the sale of mortgaged or pledged property by a lender. Treas. Reg. § 1.166-6(b) “Realization of gain or loss” states:
(1) “Determination of amount” – If, in the case of a sale described in paragraph (a) of this section, the creditor buys in the mortgaged or pledged property, loss or gain is also realized, measured by the difference between the amount of those obligations of the debtor which are applied to the purchase or bid price of the property and the fair market value of the property.
(2) “Fair Market value defined.” – The fair market value of the property for this purpose shall, in the absence of clear and convincing proof to the contrary, be presumed to be the amount for which it is bid in by the taxpayer.
Usually lenders bid in the foreclosed property the amount they are owed. If a fair market value is not reported on the 1099-C (which would qualify as “clear and convincing proof”), the taxpayer can claim the amount bid in by the lender is the fair market value and will likely remove their cancellation of indebtedness income. Even if a fair market value is reported on the 1099-C by the lender, one could still argue it is not “clear and convincing proof” if the student attorney has their own facts or property values to dispute the lender’s figure.
Debt cancelled in wrong year
I.R.C. § 451 and Treas. Reg. § 1.451-2 provide that an item of gross income is includable in the year the income is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer could have drawn upon the amount during the taxable year. Student attorneys have argued that the lender issued their 1099-C in the wrong tax year because the debt was actually cancelled in a prior tax year. This argument should be used in conjunction with another exclusion or defense, since it only reflects on the poor accounting practices of the lender and not whether the taxpayer actually had income.
Insolvency is a statutory exclusion to cancellation of indebtedness income contained in I.R.C. § 108(a)(1)(B). A taxpayer is insolvent to the extent that their liabilities exceed the fair market value of their assets. I.R.C. § 108(d)(e). Cancellation of indebtedness income can be excluded to the extent that the taxpayer is insolvent. I.R.C. § 108(a)(3).
Student attorneys should obtain their client’s credit report and the client should be interviewed about what assets (home, vehicles, bank accounts, personal property, etc.) and liabilities (mortgage, credit card debt, loans, etc.) he or she has. A free credit report can be obtained from https://www.annualcreditreport.com/cra/index.jsp.
If the insolvency exclusion is asserted in any memorandum to the IRS, a chart showing the taxpayer’s assets and liabilities should be included for clarity.
|Personal Possessions:||$ 4,100|
|1. Vehicle:||$ 3,500|
|2. Vehicle:||$ 400|
|3. Home Furnishings||$ 90|
|4. Clothing||$ 70|
|5. Cash||$ 30|
|Total Assets||$ 58,190|
|Home Loan||$ 102,888|
|Car Loan||$ 1,633|
|Credit Card Debt||$ 8,785|
|Utilities Debt||$ 584|
|Outstanding Tax Liab.||$ 2,830|
|Accounts Debt.||$ 4,340|
|Communication Debt||$ 400|
|Total Liabilities||$ 121,460|
Total Insolvency ($ 67,270)
Disputed Debt Doctrine
This doctrine can also be used in conjunction with I.R.C. § 108(d). I.R.C. § 108(d) defines the term “indebtedness of the taxpayer” (as the term is used in I.R.C. § 108) as “any indebtedness: (A) for which the taxpayer is liable, or (B) subject to which the taxpayer holds property.” A student attorney can argue that if a taxpayer is disputing, in good faith, the amount of the debt they owe and a settlement has not been reached, then the taxpayer is not liable as for the tax liability pursuant to Zarin and I.R.C. § 108(d) since they are not liable for the debt.
- IRS, Relief for recipients of mortgage debt relief
- Home Foreclosure and Debt Cancellation
- Proposed amendment to regulation to remove the 36-month non-payment testing period as an identifiable event under § 6050.
- Revenue Procedure 2015-57 – No Cancellation of Debt income for forgiveness of student loans from closed schools.
- Publication 4681 – Canceled Debts, Foreclosures, Repossessions and Abandonments.
- Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)
- Sample Memo, Cancellation of Debt (Personal Property)
- Sample Memo, Cancellation of Debt (Real Property)
Earned Income Tax Credit
The disallowance of the ETIC is an issue many clients of the Tax Clinic encounter, and many times the disallowance is also accompanied by the disallowance of the Head of Household filing status (if applicable) and one or more Dependency Exemptions. These three issues, although completely separate issues with separate requirements of their own, are usually seen disallowed collectively and often require the production of the same supporting documents.
Rules & Requirements
There are several requirements a taxpayer must meet to qualify for the EITC. Section 32 of the Internal Revenue Code provides the legal basis for a taxpayer to claim the EITC. IRS Publication 17 and IRS Publication 596 provide the guidance for the application of the law by setting forth the following rules:
Always check IRC § 32 and Publication 17 for the year in question. The necessary criteria for claiming the credit change every year.
Part A: Rules for Everyone
- Taxpayer (and spouse if filing jointly) must have a valid social security number [IRC § 32(c)(1)(F)].
- Filing status is not “Married filing separately” [26 CFR § 1.32-2(b)(2)].
- Taxpayer must be a U.S. citizen or resident alien all year.
- Taxpayer cannot file Form 2555 (Foreign earned income exclusion) or Form 2555-EZ (Foreign earned income exclusion).
- Taxpayer’s investment income must be $3,400 or less.
- Taxpayer must have earned income [IRC § 32(a)(1)].
- Earned income includes: wages, salaries, tips, net earnings from self employment, gross income received as a statutory employee
Part B: Rules if taxpayer has a Qualifying Child
- A taxpayer is entitled to an increased earned tax income credit if he has a qualifying child. In addition to meeting the requirements of part A, the taxpayer is entitled to additional credit for a qualifying child if the following requirements are met:
- Qualifying child requirements:
- Relationship Test: The child must be a son, daughter or adopted child; stepson or stepdaughter; or eligible foster child or brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of them (for example, your niece or nephew).
- Adopted child – adopted child includes a child placed with taxpayer for adoption by an authorized placement agency, even if the adoption is not final. An authorized placement agency includes any person authorized by state law to place children for legal adoption.
- Grandchild – any descendant of taxpayer’s son, daughter, or adopted child. A grandchild includes taxpayer’s great-grandchild, great-great-grandchild, etc.
- Child does not have to be taxpayer’s dependent to be a qualifying child, unless he or she is married.
- Married child – If child was married at the end of the year, he or she does not meet the relationship test unless either of these two situations applies to taxpayer
- Taxpayer can claim the child’s exemption or
- The reason taxpayer cannot claim the child’s exemption is that she gave that right to the child’s other parent:
- By completing Form 8332 or a similar written statement, or
- In a pre-1985 agreement (such as a separation agreement or divorce decree).
- Eligible foster child:
- Child must have lived with the taxpayer as a member of the taxpayer’s household for the whole year,
- Taxpayer must have cared for that child as her own, and
- Residency Test: The child must have lived with the taxpayer for more than half of the year (183 days) or the whole year if the child is an eligible foster child and the home must be in the United States.
- U.S. military personnel U.S. military personnel stationed outside the United States on extended active duty are considered to live in the United States during that duty period for purposes of the EITC.
- A child who was born or died during the year is treated as meeting the residency test if taxpayer’s home was the child’s home the entire time he or she was alive during the year.
- Time that either taxpayer or child is away from home on a temporary absence due to a special circumstance as time lived at home. Examples of a special circumstance include: illness, school attendance, detention in a juvenile facility, business, vacation, and military service.
- Age Test:
- The child must be under the age of 19 at the end of the year, or
- A full-time student under age 24 at the end of the year, or
- Permanently and totally disabled at any time during the year, regardless of age.
- Relationship Test: The child must be a son, daughter or adopted child; stepson or stepdaughter; or eligible foster child or brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of them (for example, your niece or nephew).
- Full-time student – student who is enrolled for the number of hours or courses the school considers to be full-time attendance.
- Student – child must be, during some part of each of any 5 calendar months during the calendar year:
- A full-time student at a school that has a regular teaching staff, course of study, and regular student body.
- A student taking a full-time, on-farm training course given by a school described in (i), or a state, county, or local government.
- The 5 calendar months do not have to be consecutive.
- School – A school can be an elementary school, junior or senior high school, college, university, or technical, trade, or mechanical school. However, on-the-job training courses, correspondence schools, and night schools do not count as schools for the EITC.
- Vocational high school students – Students who work in co-op jobs in private industry as a part of a school’s regular course of classroom and practical training are considered full-time students.
- Night school – Person is not a full-time student if he or she attends school only at night. However, full-time attendance at a school may include some attendance at night as part of a full-time course of study.
- Permanently and totally disabled – Person is permanently and totally disabled if both of the following apply
- He or she cannot engage in any substantial gainful activity because of a physical or mental condition.
- A doctor determines the condition has lasted or can be expected to last continuously for at least a year or can lead to death
- The taxpayer’s qualifying child cannot be the qualifying child of another person with a higher modified Adjusted Gross Income.
- If the child meets the relationship, residency and age test for more than one taxpayer, then the person with the higher modified AGI is the only one who may be able to claim the EITC using that child. The person with the lower modified AGI cannot use that child to claim the EITC. This is true even if the person with the higher modified AGI does not claim the EITC or meet all of the rules to claim the EITC.
- Taxpayer cannot be the qualifying child of another person.
Part C: Rules if taxpayer does not have a qualifying child
- Must meet all requirements of Part A
- Taxpayer must be at least 25 years of age but under 65 at end of the year.
- If taxpayer is married and filed jointly, then it does not matter which spouse meets the age test, as long as one of the spouses does.
- Taxpayer cannot be the dependent of another person.
- Taxpayer cannot be the qualifying child of another person.
- Taxpayer must have lived in the U.S. more than half the year.
Part D: Figuring and Claiming the EITC
1. The income used for the phase-out of the EITC is the greater of a taxpayer’s adjusted gross income (AGI) or the earned income. (These amounts change from year to year. The figures below are for 2015:
- $47,747 (53,267 married filing jointly) with three or more qualifying children. Maximum EITC allowed $6,242.
- $44,454 ($49,974 married filing jointly) with two qualifying children. Maximum EITC allowed $5,548.
- $39131 ($44,651 married filing jointly) with one qualifying child. Maximum EITC allowed $3,359.
- $14,820 ($20,330 married filing jointly) with no qualifying children. Maximum EITC allowed $503.
Disallowance of the EITC
If taxpayer’s EITC claim for any year after 1996 was denied or reduced for any reason other than a mathematical or clerical error, he must attach a completed Form 8862 to his next tax return if he wishes to claim the EITC.
If taxpayer is required to attach Form 8862 to taxpayer’s tax return, and taxpayer claims the EITC without attaching a completed Form 8862, taxpayer’s claim will be automatically denied. This is considered a mathematical or clerical error. Taxpayer will not be permitted to claim the EITC without a completed Form 8862.
If taxpayer’s EITC claim for any year after 1996 was denied and it was determined that his error was due to reckless or intentional disregard of the EITC rules, then he cannot claim the EITC for the next 2 years. If his error was due to fraud, then he cannot claim the EITC for the next 10 years.
Documents to Support EITC Claim
Never send originals to the IRS, only copies, and return all originals to the client after copying. When the IRS questions a client’s dependency exemptions or the EITC, it sends a Form 886-H-EITC that lists necessary documents needed to resolve the IRS’s concerns about the client’s entitlement to these items.
The documents requested include these:
- W-2’s, paycheck stubs, 1099’s, etc. for the year in question
- Taxpayer’s social security card
- Qualifying child’s birth certificate and social security card
- Lease agreement or mortgage statement showing residence for at least 183 days (generally 6 months). (If the taxpayer has a PO Box address, a copy of Postal form 1093 can be requested from the Post Office to obtain the client’s geographical address)
- Qualifying child’s school records showing dates of attendance, name of guardian and address of the child’s home
- Letter from child’s caregiver on letterhead or notarized indicating dates child was under care, name of guardians and address of the child’s home
- Child’s medical records showing date of service and child’s address
- Affidavits from friends, family and neighbors
- EITC Required Document Checklist
- Sample Document Request Letter
- EITC and Other Refundable Credits Toolkit for Tax Preparers
- Treas. Reg. § 1.32-2: Earned income Credit for taxable years beginning after December 31, 1978 (4/02)
- Treas. Reg.§ 1.32-3: Eligibility requirements after denial of the earned income credit (4/02)
- 102.3 Information Systems Multifunctional Handbook, Chapter 49, Command Code EICMP
IRS Publications and Forms
First-time Homebuyer Credit
The credit’s name is misleading. A first-time homebuyer is defined as an individual who did not have an ownership interest in a principal residence for the three years preceding the purchase of a home. § 36(c)(1). The credit was extended to include homebuyers who had owned a principal residence for five of the previous eight years. § 36(c)(6).
Depending on the purchase date, the credit served as either an interest-free loan or an outright grant. For individuals taking the credit on a purchase before January 1, 2009, the amount of the credit must be repaid in equal annual installments over a 15 year recapture period beginning in the second tax year following purchase (approximately $500 per year for those who received the maximum credit for those years, $7,500). § 36(f)(1). Because the recapture appears on the taxpayer’s income tax return, during the recapture period the taxpayer must file a return even if their income is less than the filing requirement. § 36(e).
If the home is sold before the recapture period ends, the recapture is accelerated, except on the death of the taxpayer, an involuntary conversion, a transfer between spouses, or a transfer incident to divorce. § 36(f)(2) and (4). The amount of accelerated recapture is limited by the amount of gain on the sale. § 36(f)(3)
If the credit was taken on a purchase after January 1, 2009, recapture is waived and accelerated recapture, subject to the exceptions described above, can only be triggered in the first 36 months of ownership. § 36(f)(4)(D).
Filing Status: IRC § 2
An individual may be eligible to file a return as an unmarried individual, head of household, married individual filing a joint return, or as a married individual filing a separate return. The type of filing status impacts the tax rate, the amount of standard deduction, and whether certain deductions or subtractions from income are allowed.
Generally, a person who is not married must file as single, unless head of household is available. This status is determined on the last day of the year. For example, if the taxpayer were to marry on December 31 then his or status is married or married filing separately but not single. On the other hand, if a client were to obtain a divorce on the last day of the year he or she could file as single or head of household.
Head of Household:
The head of household filing status defined in § 2(b) offers an alternative for single filing status for a single individual if the individual is entitled to claim a “qualifying child” or certain “dependents” for whom the taxpayer is entitled to a deduction under § 151 . A person who is married may not file as head of household. See § 7703 for determination of marital status that allows certain individuals who are married to be treated as single. The tax rate for the head of household filing status is usually lower than the single and married filing separately tax rates. A taxpayer who qualifies for the head of household filing status will also receive a higher standard deduction than if the individual had filed as single or married filing separately.
Many of the taxpayers who come to the Clinic have had their head of household status disallowed. In many instances, these taxpayers were audited because of their Earned Income Tax Credit (EITC) claims. Once their EITC claims were disallowed, their Head of Household filing status and dependency exemptions are usually also disallowed.
Requirements for Head of Household
Section 2 (b) and IRS Publication 17 applicable to the year in question should be consulted because some of the requirements for head of household change from year to year. IRS Publication 17 provides guidance as follows:
- The taxpayer must be unmarried or considered unmarried on the last day of the tax year. A taxpayer is considered unmarried under IRC § 7703 if on the last day of the year if they are legally separated from their spouse, according to the law if the state taxpayer resides in, under a divorce or separate maintenance decree, or the taxpayer meets all of the following tests:
(a) Taxpayer filed a separate return.
(b) Taxpayer paid more than half the cost of keeping up taxpayer’s home for the tax year.
(c) Taxpayer’s spouse did not live in taxpayer’s home during the last 6 months of the tax year. Spouse is considered to live with taxpayer even if they are temporarily absent due special circumstances.
(d) Taxpayer’s home was the main home of the child, stepchild, or eligible foster child for more than half the year.
(e) Taxpayer must be able to claim an exemption for the child. Taxpayer may still meet this test if they cannot claim the exemption because the noncustodial parent is allowed to claim the exemption for the child.An individual is considered unmarried for Head of Household purposes if the spouse is a nonresident alien at any time during the year, and taxpayer chooses not to treat the nonresident spouse as a resident alien. However, the spouse is not a qualifying person for Head of Household purposes.
Even if an individual is considered unmarried for Head of Household purposes because the taxpayer is married to a nonresident alien, taxpayer is still considered married for purposes of EITC. Taxpayer cannot claim EITC unless the taxpayer files a joint return with the taxpayer’s spouse.
- The taxpayer must have paid more than half the cost of maintaining a home for the tax year.
- A qualifying person lived with the taxpayer for more than half the year (except for temporary absences, such as school). A qualifying person for the purposes of the Head of Household filing status is defined in § 2(b)(1)(A) to be either a “qualifying child” dividend in § 152(c) or a “dependent” other than a “dependent” described in § 152(d)(2)(H) or § 152 (d)(3)
Documents to Support Head of Household Status
- Copy of lease showing taxpayer as primary tenant*
- Copy of mortgage if taxpayer owns home *
- Paid utility bills for the taxpayer home with canceled checks
- School records listing the qualifying person’s address
- Medical records listing the qualifying person’s address
- Usually, the documents used to support dependency exemptions can also support Earned Income Credit and Head of Household. *If the taxpayer has a PO Box as the address, a copy of Postal form 1093 can be requested from the Post Office to obtain geographical address.
Married Filing Jointly
A husband and wife may file a joint return even though one spouse has no income or deductions and even though they are not living in the same household. (Treas. Reg. sec.1.6013-1 and 1.6013-4) but only if:
- Their tax years begin on the same date,
- They are not legally separated under a decree of divorce or separate maintenance on the last day of the tax year, and
- Neither is a nonresident alien at any time during the year.
However, a U.S. Citizen or resident and his/her nonresident alien spouse can elect to file a joint return if they agree to be taxed on their worldwide income and supply all necessary books and records and other information pertinent to the determination of tax liability (Code sec. 6013(g). Also, a one-time election to file a joint return is available in the year in which a nonresident alien becomes a resident (Code sec. 6013(h).
Election to file joint return: This election is made at the time that the tax return is filed. This election can be amended by filing an amended return (1040X) within the 3 year period for amending the that year’s tax return . Note, however, that filing status cannot always be changed. For example, while a taxpayer can change his or her filing status from a separate return to a joint return, he or she cannot file a separate return for a tax year after filing a joint return for that year, subject to some narrow exceptions, such as a personal representative for a decedent changing a joint return to a separate return if the surviving spouse elected a joint return (the deadline for this is one year from the return due date including extensions–see IRS Publication 17) or certain situations in which the marriage was invalid or there was a forged signature (see I.R.M. 220.127.116.11.7 (08-21-2015).
Married couples are entitled to file joint tax returns but this method of filing should be carefully considered prior to filing if the Taxpayer is involved in divorce proceedings or anticipates divorce proceedings. Taxpayers who file joint returns are jointly and severally liable.
Married Filing Separately:
This is the default filing status for those who are married, not legally separated or not considered married (see discussion above on Head of Household) but do not wish to elect married filing jointly. Generally, this is considered to be the least advantageous to the taxpayer. However, there are other personal or business reasons for a husband and wife to elect married filing separately. One of those situations occurs with the Clinic client when they are anticipating a divorce or there is spousal abuse.
Joint return after Filing Separate Return: For some of our clients, the one or both of the married couple filed separate returns. Hindsight indicates filing jointly may have been more advantageous. Treas. Reg. Section 1.6013-2 provides the IRS’s guidance on when this can occur.
In general, an individual who files a separate return for a taxable year for which a joint return could have been made by him and his spouse under section 6013(a) can amend that return. This period is generally the 3 year period to amend the return from the date of required filing without considering any extensions granted to either party. There are many complex rules provided for in the above regulation, however these are rarely seen in the Tax Clinic.
Limitation on making the Election: A joint return under I.R.C. section 6013(b)(1) cannot be elected:
- After July 30, 1996 unless the full tax is paid due on the separate returns the full tax due before filing the joint return.
- After expiration of the 3 year period from the last day prescribed by law for filling the return without regard to any extensions of time granted to either spouse; or
- After there has been mailed to either spouse, with respect to that year, a notice of deficiency under I.R.C. section 6212, if either spouse files a petition with the Tax Court timely; or
- After either spouse commences a suit in any court for recovery of any part of the tax for that taxable year; or
- After either spouse has entered into a closing agreement under section 7121 as to that taxable year, or after any civil or criminal case arising against either spouse as to that taxable year is compromised under I.R.C. 7122.
The Tax Court has ruled that a couple could elect to file a joint return even though the IRS had previously prepared and filed returns for the husband with a status of married filing separately (JU.V. Millsap, 91TC 926 (1988). The IRS filing of substitute returns did not bar the taxpayers from contesting whether the deficiency or the IRS’s choice of his filing status.
Internal Revenue Code
- IRC § 2 Definitions and Special Rules
- IRC § 7703 Determination of marital status
- Treas. Reg. § 1.2-1 Tax in case of joint return of husband and wife or the return of a surviving spouse (4/00)
- Treas. Reg. § 1.2-2 Definitions and special rules (4/00)
IRS Forms and Publications
- IRS Publication 17 Chapter 2 Filing Status
- Tax Topic 353 Filing Status
- Sample Filing Status Memorandum
Flowchart for Determining Appropriate Filing Status
Tax Clinic Identity Theft Procedures
One of the defenses to the assertion of a federal income tax deficiency is that the tax is being imposed on income the taxpayer did not earn. This can be the result of someone else using the taxpayer’s social security number to a file fraudulent tax return, oftentimes seeking a refund that may or may not be owed to the innocent victim. In other circumstances, a taxpayer will have his social security number stolen to enable the thief’s wages to be reported on a tax return on which the stolen social security number is used.
Cases of identity theft have increased to the point that the IRS has created an identity theft unit. Correspondence to this unit should be sent to IRS Identity Protection Specialized Unit, 310 Lovell St., Andover, MA 01810-5430. For emergencies the unit can be reached at 800-908-4490. Once the identity theft matter has been brought to the attention of the IRS, the IRS may issue a PIN to use when the taxpayer files his return. If the client receives a PIN, that is the only PIN the client should use. See Notice 2010 TNT 245-16
When handling an Identity Theft Case after filing of the power of attorney but before initiating any contact with the IRS, obtain the account, wage and income transcripts, and tax return transcripts. Once the IRS has notice of a possible Identity theft, the IRS adds a code that prevents access to the accounts through e-services. When contacting the client, inquire if the client has contacted the IRS and caution him not to do so until you have had a chance to review the account.
There are three courses of action available when identity theft occurs, depending on whether the client contacts the clinic before issuance of a Statutory Notice of Deficiency (“90-day letter”), during the pendency of the 90-day letter, or after the tax is assessed and the client is receiving collection notices or in many instances when the IRS begins levying against the client’s assets.
If the clinic is contacted before issuance of the Statutory Notice of Deficiency, the notebook and memorandum will be directed to the Examination Division. If the clinic is contacted while a statutory notice of deficiency is pending, a petition to the United States Tax Court should be filed and then a memorandum and notebook should be prepared for submission to the appeals officer or chief counsel attorney. If the clinic is contacted after the tax is assessed, the memorandum and notebook are sent to the IRS Identity Protection Specialized Unit, at 310 Lovell St., Andover, MA 01810-5430.
Once the IRS becomes aware of a potential identity theft issue, the IRS usually prevents a taxpayer’s representative from reviewing a taxpayer’s e-services on-line information, discussing the case with an IRS representative, and in some situations the IRS even refuses to discuss the case with the client. When contacting the IRS, the first step is to request that the IRS unlock the ID theft block. If the IRS will not, then ask if they will fax the transcripts to the clinic fax number. Absent the IRS’ willingness to do either, the student attorney can prepare a letter signed by the client, a sample of which is included below. In some instances the letter from the client may cause the IRS to unblock the account. This letter procedure is time consuming and should not be used as the preferred method of resolution unless the client wants a copy of the fraudulent return. It is more expeditious to prepare an ID Theft package with memorandum.
To make the request, a signed letter with the following information should be sent to the IRS:
- Our relationship to the victim of identity theft as authorized representative
- Our mailing address
- Your CAF number
- Tax year(s) of the fraudulent return(s) you are requesting
- Client’s name and social security number
- Client’s mailing address
- The following statement, with your signature beneath: “I declare that I am a person authorized to obtain the tax information requested.”
You may request a redacted copy of the fraudulent tax return that was filed and accepted by the IRS. The victim’s name and social security number must be listed as a filer (not a dependent) on the fraudulent return. Otherwise, the IRS cannot disclose the return information. The redacted fraudulent return will feature enough information for you to determine how your client’s personal information was used.
Your letter must be accompanied by a copy of a government issued identification card (ex. driver’s license), as well as a copy of the clinic’s power of attorney (IRS Form 2848), and any additional documentation to the following address:
Internal Revenue Service
P.O. Box 9039
Andover, MA 01810-0939
Contents of Notebook and Memorandum
An identity theft notebook should include the following information:
- Form 14039: Ensure that this form is properly prepared and signed by the taxpayer. Verify that the current version is used by checking the IRS website.
- A memorandum with the statement of the facts. (See sample memos below.)
- A valid form of identification such as a driver’s License, military ID, state identification card, Social Security Card, passport, etc.
- Credible documentary evidence of the identity theft, which will be attached as exhibits to the memorandum. A police report and an FTC identity theft affidavit provide further evidence to support the client’s claim. The client should contact the police department in his local jurisdiction to file a report. The police department will provide a copy which can be used as evidence. The FTC affidavit is available online and includes a printable page for the client to sign.
The memorandum should include the following:
- An introduction. Briefly describe the theft of identity (just a couple of sentences).
- Tax history section. Describe in detail the taxpayer’s prior filing history up to the time his identity was stolen. Point out what actions the client took to prepare a correct return for the year of the identity theft. If the client has no filing requirement, establish this with a transcript of the wage and income reported to the IRS. If some of the W-2s or 1099s are not the client’s, discuss these in the factual analysis section below. If the client has a filing requirement without regard to the fraudulent income items, the original executed copy of a correct return should be prepared and submitted with the notebook.
- Personal Historical Background. Describe the client’s personal background, health, educational history, work history (with particular attention to his work history at the legitimate employer), and where he lives. In cases where a fraudulent return or wage report (W-2 or 1099) has been filed by someone other than the client, you can contrast the client’s actual address with the reported address.
- Factual Analysis. Demonstrate that the income is not that of the client. This discussion and factual analysis may include:
- A showing that the client could not have worked at the particular other source of income by showing that it was located in another state or across town and they couldn’t be in two places at once. This is useful when a client’s Wage & Income transcript includes income from jobs the client did not have. Use internet tools to demonstrate this, such as MapQuest or Google maps. Obtain an affidavit from the actual employer that attests to the fact that the client had a 40 or more hour a week job. Obtain any vacation records showing he did not take time off on the dates and times when he was supposed to have worked at the other job. In some instances ACCURINT will assist you with proof;
- A showing that the client does not resemble the person that used his/her ID;
- A showing that none of the income has shown up in his/her bank account(s). Demonstrate this by including bank statements for the period of the identity theft. It may be necessary to include 12 months of statements;
- Verification from the employer that issued the suspect 1099 or W-2 of whether the employer ever employed the client.
- If tax arises from unallowable deductions that were claimed to obtain the Earned Income Tax Credit, point out that the client could not have incurred those expenses.
- Describe the harm suffered by the client from the identity theft. Some examples of harm include: bank accounts have been tampered with, fraudulent signatures on checks or other documents, or copies of 1099s or W-2s that the client indicates are not his.
- Applicable Law
- Application of Law to the Facts; and
The IRS Identity Theft form, valid identification, and the evidence described above are included as exhibits to the memorandum. Ensure that a complete and exact copy of the entire notebook is retained as a file copy. It should also be scanned and saved to the client’s file.
After review of the memorandum by the Clinic Director is complete, the completed (ready for mailing) copy should be submitted to the Associate Clinic Director along with the file copy. The Associate Clinic Director will initial the file copy to acknowledge that the original is ready to be mailed.
For cases where the tax has been assessed, the student should follow-up at a minimum within 10 days of mailing to ensure that the notebook was received and then each 30-45 days thereafter. For follow up you can use the IRS Identity Protection Specialized Unit hotline (1-800-908-4490). Use this number only for previously submitted matters. For docketed cases, the student should follow up with the appeals officer or chief counsel attorney. The IRS is currently using a CP01 notice to inform the client that the IRS has received the information, verified the claim of identity theft, and placed an identity theft indicator on the account. See the sample CP01 Notice below.
Return Preparer Fraud
Tax Clinic Return Preparer Fraud Procedures
The defense that a taxpayer can raise of Return Preparer Misconduct (“RPM”) is related to identity theft because the taxpayer is claiming the filed return is null based on the fact that it was not the document that the taxpayer authorized. However, RPM only applies to a sub-set of identity theft scenarios. The IRS defines RPM as occurring when “the tax return preparer completes a return for a taxpayer and without the taxpayer’s knowledge makes changes to the return, which results in an improper refund to the preparer or a third party.” (IRS IGM Return Preparer Fraud or Misconduct, June 5, 2012). If the taxpayer, rather than the preparer or a third party, received an improper refund as a result of RPM, there is a mechanism in place under the RPM guidance to adjust the taxpayer’s account to reflect the appropriate refund. An RPM defense cannot be raised if the improper refund was the result of merely incorrect advice from the return preparer (e.g., a return preparer erroneously believed that personal apartment rent is a deductible expense)
Examples of RPM include: (1) the preparer submits a fraudulent Schedule C reporting fictitious business expenses, reducing the taxpayer’s taxable income; (2) the preparer submits a fraudulent Schedule A reporting itemized deductions for fabricated charitable contributions; or (3) the preparer includes false dependents to increase the taxpayer’s EITC. In many cases, the return preparer will have requested that the refund be split so the taxpayer receives the expected refund while the excess is diverted to the return preparer.
There are three sources of information to consult when addressing RPM issues:
- IRM 25.24, Return Preparer Misconduct Program (applies only to cases not covered by the interim guidance below);
- WI-25-1215-004, Interim Guidance on Allegations of Return Preparer Misconduct for IDTVA RPM Accounts Management (AM) ONLY for Cases Tax Year 2013 (and prior) Received On or Before 12/31/2015 (only for cases prior to tax period 2014 that were suspended on or before December 31, 2015); and
- WI-25-1215-003, Interim Guidance on Allegations of Return Preparer Misconduct for the Identity Theft Victim Assistance – Compliance (IDTVA-C) ONLY for Tax Year 2013 and Prior (Suspended Cases Only) (only for cases prior to tax period 2014 that the IRS received on or before December 31, 2015).
In the latter two documents interim guidance is provided. In the first item, a new Internal Revenue Manual section is added. These pronouncements set forth the Commissioner agreement to issue refunds where the preparer filed an improperly altered return for a taxpayer that resulted in an improper refund sent to someone other than the taxpayer. If the taxpayer received the full improper refund as a result of RPM, then these materials provide a mechanism for the IRS to adjust the taxpayer’s account to reflect the proper refund. The IRS issued the interim guidance for a number of cases pending where the IRS did not believe it had the authority to issue refunds where the return preparer took the refund.
Handling a Return Preparer Misconduct Case
In response to the growing number of RPM claims, the IRS has created a special reporting process. If the Clinic is contacted before issuance of the statutory notice of deficiency (90-day letter), the brief, with accompanying exhibits, should be directed to Examination Division. If the Clinic is contacted while a 90-day letter is pending, a petition to the United States Tax Court should be filed and then the documents should be submitted to the Appeals Officer or Chief Counsel Attorney. If the Clinic is contacted after the tax is assessed, the documents should be sent to:
Internal Revenue Service
AM – Preparer Complaints
Mail Stop 58
5333 Getwell Road
Memphis, TN 38118
Contents of Memorandum and Notebook
To claim a refund, the documents to include in the notebook submitted to the IRS should include the brief, exhibits, Forms 14157 and 141517-A, and a signed return with the correct information, a supporting memorandum, exhibits that substantiate the taxpayers allegations, and a signed statement from the taxpayer stating that the taxpayer had no knowledge of the changes that the preparer made to the return. The statement should end with this phrase above the signature: “This statement is true to the best of my knowledge and belief, under penalties of perjury.”
In any RPM claim, the IRS now requires the following documentation (see IRM 18.104.22.168):
- Form 14157, Complaint:
- Form 14157–A, Tax Return Preparer Fraud or Misconduct Affidavit
- The return preparer’s name and address
- Signed, valid tax return of the taxpayer submitted with the claim
- Official report from a law enforcement agency (only in cases where the taxpayer is seeking an additional refund) that is signed by a police officer or equivalent and that contains: (1) the relevant tax years; (2) the return preparer’s first and last name and address; and (3) a statement that describes the RPM and the theft of the refund.
- Signature of the tax return preparer on the return that the preparer filed by the preparer or, if it is an electronic return, the preparer information. If there is no signing preparer, additional corroborating evidence for the ghost preparer is required. See the specific ghost preparer documentation requirements in I.R.M. 22.214.171.124.
Exhibits should support the RPM claim by establishing, as follows:
- If the improper refund was not received by the taxpayer:
- Bank statements showing a refund deposit for the correct refund and not the excess
- IRS records indicating that the refund check was mailed to an address not connected with the taxpayer
- If the return, as filed, was not signed by the taxpayer:
- A copy of the return given to the taxpayer by the preparer showing different information than the return filed
- A signature on the return that does not match the taxpayer’s signature
- The taxpayer authorized electronic filing and did not have the opportunity to review the return as filed
- If the return preparer has a history of RPM:
- Online forums in which other taxpayers report RPM
- News stories reporting government investigations or prosecution for RPM
After the Clinic Director reviews the brief, the completed (ready for mailing) copy should be submitted to the Associate Clinic Director along with the file copy, who will initial the file copy to acknowledge that the original is ready to be mailed. Ensure that a complete and exact copy of the entire notebook is retained as a file copy. It should also be scanned and saved to the client’s file.
- Letter requesting copy of ID Theft Return
- Sample Memo, Identity Theft
- Sample Memo, Fraudulent Return
- Sample Memo, Fraudulent W-2
- Sample Memo, Return Preparer Fraud
- Identity Theft Affidavit – IRS Form 14039
- Pub. 4535 (EN/SP) (Rev. 10-2008) – Identity Theft Prevention and Victim Assistance
- I.R.M. 126.96.36.199 (10-1-2010), Accounts Management Identity Theft
- I.R.M. 5.1.12 , , Collection Procedures, Cases Requiring Special Handling
A taxpayer who has income and withholding’s or estimated tax payments and who files a joint return with an individual who owes past-due child support requests a refund of his or her allocation of the joint return refund on Form 8379, Injured Spouse Claim and Allocation).
- The taxpayer seeking relief is not required to pay the past due amounts; rather, the spouse in default is responsible for the debt
- The taxpayer reported income such as wages, taxable interest, etc. on the joint return
- The taxpayer made and reported payments such as Federal income tax withheld from taxpayer’s wages or estimated tax payments or the taxpayer claimed the Earned Income Tax Credit or other refundable credit
- Form 8379
Documents on IRS.gov
- IRS Form 8379: Injured Spouse Claim and Allocation
Relief from Joint and Several Liability § 6015
Married taxpayers who file a joint return under § 6013 are jointly and severally liable for any tax, interest and penalties due as shown on the return and also any additional tax liability the IRS determines to be due. § 6013(d)(3). Relief from joint and several liability may be available under IRC § 6015. If it is established that the taxpayer signed a joint return under duress, then a joint return has not been filed. In this situation, there is no joint and several liability; however, the taxpayer may have to file a separate return for the year. Even if the taxpayers later divorce or if the other spouse earned all the income joint and several liability exists. When relief is requested, Form 8857 must be filed with a brief that addresses the requirements for relief. Relief may be requested during any state if a tax controversy, including pre-assessment and collections as set forth in the statute and Treasury pronouncements for relief. The rules for relief from joint and several liability should not be confused with the injured spouse rules (discussed elsewhere on this website) that provide for an allocation of an over-payment using Form 8379.
Three forms of relief from joint and several liability are available:
- Innocent Spouse Relief – § 6015(b)
- Separation of Liability – § 6015(c)
- Equitable Relief – § 6015(f)
If relief is requested under § 6015 (b) or (c) and it is denied, the IRS may consider relief under § 6015(f).
Guidance on the administrative appeals rights for the non-requesting spouse is contained in Rev. Proc. 2003-19.
Innocent Spouse Relief § 6015(b)
To receive “innocent spouse relief” the taxpayer must:
- File a joint return that had an “understatement” (not an underpayment) of tax due to “erroneous items” of one of the spouses.
- Establish that at the time he signed the joint return he did not know, and had no reason to know, that there was an understatement of tax;
- Prove that taking into account the facts and circumstances, it would be unfair to hold the taxpayer liable for the understatement of tax, and
- Elect relief no later than two years after collection activity begins with respect to the requesting spouse.
An understatement of tax is generally the difference between the total tax liability that should have been shown on the return and the amount that was actually shown on the return. § 6662(d)(2)(A). This is to be contrasted with an underpayment of tax. An underpayment of tax is an amount of tax the taxpayer reported on the return but did not pay. For example, a joint 2014 return shows that the taxpayer and his spouse owe $5,000 but the IRS determines that they owe $6,000. They paid $2,000 with the return and in tax withholding. They have an underpayment of $3,000 and an understatement of $1,000.
A taxpayer may qualify for partial relief if, under § 6015(b), at the time she filed her return, she knew or had reason to know that there was an understatement of tax due to her spouse’s erroneous items, but she did not know how large the understatement was. She will be relieved of the understatement to the extent she can prove that she did not know and had no reason to know about a portion of the understatement. Refunds are permitted under § 6015(b)
The term “erroneous item” is broadly defined as:
- Any gross income item received by the spouse that is not reported.
- Any improper deduction, credit, or property basis claimed on the return.
The following are examples of erroneous items:
- The expense for which the deduction is taken was never paid or incurred. For example, the non-requesting spouse, a cash-basis taxpayer, deducted $10,000 of advertising expenses on Schedule C (Form 1040), but never paid for any advertising.
- The expense does not qualify as a deductible expense. For example, the spouse claimed a deduction of $10,000 for the payment of state fines. Fines are not deductible.
- No factual argument can be made to support the deductibility of the expense. For example, the non-requesting spouse claimed $4,000 for security costs related to a home office, but the taxpayer did not have a home office.
When requesting relief both the clients’ knowledge and whether it is unfair to hold the taxpayer liable must be specifically addressed.
Regulation § 1.6015-2(c) states that a requesting spouse has knowledge or reason to know of an understatement if he or she actually knew of the understatement, or if a reasonable person in similar circumstances would have known of the understatement. Facts that should be addressed when determining whether a requesting spouse had reason to know of an understatement include, but are not limited to:
- The nature of the erroneous item and the amount of the erroneous item relative to other items;
- The couple’s financial situation;
- The requesting spouse’s educational background and business experience;
- The extent of the requesting spouse’s participation in the activity that resulted in the erroneous item;
- Whether the requesting spouse failed to inquire, at or before the time the return was signed, about items on the return or omitted from the return that a reasonable person would question; and
- Whether the erroneous item represented a departure from a recurring pattern reflected in prior years’ returns.
The IRS will consider all of the facts and circumstances of the case in order to determine whether it is unfair to hold the taxpayer responsible for the understatement. Two indicators the IRS may use in deciding that it is unfair to hold the taxpayer responsible and that should be addressed are whether she:
- Received any significant benefit from the understatement of tax,
- Taxpayer can receive significant benefit either directly or indirectly. For example, if the spouse did not report $10,000 of income on the joint return, the taxpayer can benefit directly if the spouse shares that $10,000 with her. She can benefit indirectly from the unreported income if the spouse uses it to pay extraordinary household expenses.
- The taxpayer does not have to receive a benefit immediately for it to be significant. For example, money the spouse gives the taxpayer several years after he received it or amounts inherited from the spouse (or former spouse) can be a significant benefit.
- Support payments that the taxpayer receives as a result of a divorce proceeding are not a significant benefit.
- Was later divorced from or deserted by the spouse.
Relief By Separation of Liability § 6015(c)
Under this type of relief, a taxpayer may elect allocation of the understated tax (plus interest and penalties) on the joint return between the taxpayer and the spouse (or former spouse). This type of relief is not available for an underpayment of tax, and refunds are not granted. When relief is granted, the understatement of tax allocated to the taxpayer is generally the amount for which he or she is responsible. Taxpayers may request this type of relief in addition to innocent spouse relief.
To request separation of liability relief, a taxpayer must have filed a joint return, the request for relief must be filed no later than 2 years from when collection activities began with respect to the requesting spouse, and Form 8857 must be filed. The taxpayer also must meet one of the following requirements at the time he or she files the request for relief.
- The taxpayer must no longer be married to, or is legally separated from, the spouse with whom the joint return was filed from which relief is requested. Under this rule, a taxpayer is no longer married if he is widowed. Marital status is determined as of the date the election is filed. See § 7703 for purposes of determining marital status, or
- Taxpayer must not be a member of the same household as the spouse with whom the joint return was filed at any time during the 12-month period ending on the date he files Form 8857. Even if the taxpayer meets these two requirements, a request for separation of liability will not be granted in the following situations:
- The IRS proves that the taxpayer and her spouse transferred assets to third parties as part of a fraudulent scheme.
- The IRS proves that at the time the taxpayer signed the joint return, she had actual knowledge of any items giving rise to the deficiency that were allocable to the spouse. (For a discussion of what constitutes “actual knowledge” Reg. § 1.6015-3(c)(2) and see IRS Publication 971.)
- The spouse (or former spouse) transferred property to the taxpayer to avoid tax or the payment of tax. If the spouse transfers property to the taxpayer for the purpose of avoiding tax or payment of tax, the tax liability allocated to the taxpayer will be increased by the value of the property transferred. A transfer will be presumed to have as its main purpose the avoidance of tax or payment of tax if the transfer is made after the date that is one year before the date on which the IRS sent its first letter of proposed deficiency allowing the taxpayer an opportunity for a meeting in the IRS Appeals Office. This presumption will not apply if the transfer was made under a divorce decree, separate maintenance agreement, or a written instrument incident to such an agreement. The presumption will also not apply if the taxpayer establishes that the transfer did not have as its main purpose the avoidance of tax or payment of tax.
Equitable Relief § 6015(f)
If the taxpayer does not qualify for innocent spouse relief or relief by separation of liability, the taxpayer may still be relieved of joint and several liability if the taxpayer qualifies for equitable relief. If a taxpayer requests equitable relief and it is denied, the IRS may not consider relief under § § 6015 (b) or (c) unless the taxpayer affirmatively elects relief under one or both of those provisions.
The taxpayer may qualify for equitable relief if all of the following conditions are met:
- The taxpayer is not eligible for innocent spouse relief, relief by separation of liability, or relief from separate return liability for community income,
- The taxpayer and the spouse did not transfer assets to one another as a part of a fraudulent scheme,
- The spouse did not transfer assets to the taxpayer for the main purpose of avoiding tax or the payment of tax,
- The taxpayer did not file the return with the intent to commit fraud, and
- The taxpayer establishes that, taking into account all the facts and circumstances, it would be unfair to hold the taxpayer liable for the tax.
Unlike innocent spouse relief or separation of liability, the taxpayer may obtain equitable relief from both an understatement of tax or an underpayment of tax (defined earlier under Innocent Spouse Relief).
The IRS will consider all of the facts and circumstances in order to determine whether it is unfair to hold the taxpayer responsible for the understatement or underpayment of tax. In doing so, it will examine both positive and negative factors. When requesting relief under this ground, each of the positive and negative factors should be addressed.
The following are examples of factors that weigh in favor of equitable relief:
- Taxpayer is separated (whether legally or not) or divorced from the spouse.
- Taxpayer would suffer economic hardship and would not be able to pay reasonable basic living expenses if relief is not granted.
- Taxpayer was abused by the other spouse, but the abuse did not amount to duress.
- Taxpayer did not know and had no reason to know about the items causing the understatement or that the tax would not be paid
- The taxpayer’s spouse or ex-spouse has a legal obligation under a divorce decree or agreement to pay the tax. This will not be a positive factor if the taxpayer knew, or had reason to know, at the time the divorce decree or agreement was entered into, that the spouse would not pay the tax.
- The tax for which the taxpayer is requesting relief is attributable to the spouse.
The following are examples of factors that weigh against equitable relief:
- Taxpayer will not suffer economic hardship if relief is not granted.
- Taxpayer knew, or had reason to know, about the items causing the understatement or that the tax would be unpaid at the time she signed the return.
- Taxpayer received a significant benefit from the unpaid tax or items causing the understatement.
- Taxpayer has not made a good faith effort to comply with Federal income tax laws for the tax year for which she is requesting relief or the following years.
- Taxpayer has a legal obligation under a divorce decree or agreement to pay the tax.
- The tax for which taxpayer is requesting relief is attributable to her.
How To Request Relief
To request for Innocent Spouse Relief, Separation of Liability, or Equitable Relief, the IRS requires taxpayer to complete and file IRS Form 8857. Before the form is completed, the Regulations under § 6015 should be reviewed. They contain several examples illustrating the application of § 6015. The taxpayer only needs to file one Form 8857, even if she is requesting relief for more than one tax year. The taxpayer must attach a brief (see example below) to Form 8857 explaining why she believes she qualifies for relief . The instructions for Form 8857 contain more information pertaining to the required information. The Form 8857 and the brief are accompanied by a cover letter addressed to the IRS office in Covington, Kentucky.
The IRS is required to inform the spouse (or former spouse) if taxpayer requests innocent spouse relief or separation of liability and to allow the spouse (or former spouse) to participate in the determination of the amount of relief from liability. You should inform your client that the IRS will attempt to contact her former spouse and advise him of the request for relief. To protect victims of domestic abuse, the IRS has adopted several measures. You should consult the IRS web site in this situation and write on the top of Form 8857 “Potential Domestic Abuse Case.”
Tax Court Review of Request
Denial of a request for relief from joint and several liability may be challenged in the Tax Court. Within 90 days after the IRS mails the taxpayer a negative final determination notice indicating that the IRS denied relief from joint and several liability, the client may petition the U.S. Tax Court to review the denial. This is a statutory period of time that may not be extended. If taxpayer does not file a petition, or files it late, the Tax Court cannot review the denial for relief.
An appeal of an IRS denial of relief may be conducted under the small tax case procedures only if the amount of relief sought, including accrued but unassessed interest and penalties, does not exceed $50,000 on the date the petition is filed. Otherwise, the petition for review of the IRS’ denial of relief must be filed under the regular U.S. Tax Court procedure.
A taxpayer may also file a petition in U.S. Tax Court if she has not received a final determination notice from the IRS within 6 months from the date he or she filed Form 8857.
Innocent spouse relief can also be raised in U.S. Tax Court as a defense when a statutory notice of deficiency has been issued. If the Form 8857 has not previously been prepared, the form, with an original signature, should be included with a brief.
In this situation, the request for relief should be sent to either the appeals officer assigned or Chief Counsel attorney assigned the case.
Under limited circumstances refunds of tax are permitted if relief from joint and several liability under § 6015 is granted, as follows:
- A refund is available if relief is granted under § 6015(b) or § 6015(f), subject to the statute of limitations under § 6511;
- No refunds are available if relief is granted under § 6015(c);
When Request May Be Filed
A request for relief under § 6015(b) and (c), but not (f), must be filed no later than 2 years from when collection activity first begins after July 22, 1998. § 6015(b)(1)(E), (c)(3)(B). Reg. § 6015-5(b) currently provides that the 2 year limit on relief applies to relief requested under § 6015(f); however, first Notice 2011-70 (see link below) and later, Revenue Procedure 2013-34 (linked below) revoke so much of this regulation that limits § 6015(f) claims to a 2-year period. The period of limitations for submitting an innocent spouse claim under 6015(f) is now limited only by the 10 year statute of limitations under I.R. C. § 6502 and for refunds by the period to submit a claim for refund under I.R.C. § 6511. Revenue Procedure 2013-34 also updates the rules relating to the weight given to abuse and financial control as a defense
Collection activity for this purpose, begins when the requesting spouse receives:
- A § 6330 “Notice of Intent to Levy”;
- A § 6042 offset of an over-payment of the requesting spouse against the liability; or
- The filing of a claim by the federal government in a court proceeding in which the requesting spouse is a party or which involves property of the requesting spouse.
Collection activity does not include:
- A § 6212 “Notice of Deficiency”,
- A § 6303 “Notice and Demand for Payment”, or
- A § 6320 “Notice of Lien”
- Relief at a Glance Chart
- Innocent Spouse Brief
- Innocent Spouse Questionnaire
- Internal Revenue Service Innocent Spouse Checklist
- Innocent Spouse Relief Request Cover Letter
Information on IRS.gov
- Chief Counsel Notice 2013-011, Litigating Cases that Involve Claims for Relief From Joint and Several Liability Under Section 6015
- CC-2011-17, Change in Litigating Position on the Two-Year Deadline to Request Section 6015(f) Equitable Relief
- Notice 2011-70, Equitable Relief under Section 6015(f) – August 8, 2011
- Revenue Procedure 2003-61.pdf, New rules for applying for Innocent Spouse Relief (Scroll to page 296)
- Chief Counsel Advice.pdf Grant of Innocent Spouse Relief Does Not ‘Abate’ Tax Liability
- IRS Publication 971.pdf, Innocent Spouse Relief
- Form 8857.pdf, Request for Innocent Spouse Relief Form
- IRS Publication 3212.pdf, Innocent Spouse Relief Brochure
- Form 12508.pdf, Innocent Spouse Request for Information
- 2013 – TNT-115-13, IRS Standard of Review
- IRC §66(c) Treatment of community income: Spouse relieved of liability in certain other cases
- IRC §6013 Old section of code relating to Innocent Spouse relief
- IRC §6015 Relief from joint and several liability on joint return
Math Error Notice Rights
When tax is considered paid:
- A tax is considered paid when the IRS levies on funds of the taxpayer.
- Seized property is not considered payment until it is sold.
- Withheld income tax and estimated tax payments are considered to be paid on the date the tax return is due.
- Taxes paid through garnishments on wages and assets are considered paid on the various dates the garnishments were applied to the taxes.
- Payments made through the application of the refund for another year is considered paid when the offset was made.
Filing a Claim for Refund
Most taxpayers file a refund claim for the current year by filing a federal tax return on IRS Form 1040. Refund claims for overpaid income taxes for previous years are made by filing IRS Form 1040X for individuals or IRS Form 1120X for corporations. Refund claims for taxes other than income taxes are made on IRS Form 843. The claim must include a statement of the facts and issues as to why the taxpayer is entitled to a refund.
Refund claims for prior years will usually be examined by the Examination Division of the IRS. If the IRS denies the claim for refund by sending a statutory notice of claim disallowance or if six months pass without any action, the taxpayer may file a refund suit in either the Federal Claims Court or a U.S. District Court.
The taxpayer must file a claim for a refund within 3 years from the date the return was filed or 2 years from the date the tax was actually paid, whichever is later. IRC § 6511(a). A return is deemed filed on the due date if it was filed early. IRC § 6513(a). If no return was filed, the refund claim must be made within two years of when some portion of the tax was paid (see above for what is considered a payment).
Taxpayers may file protective claims before the expiration of the statute of limitations to preserve their right to make a claim for refund. Protective claims and real claims have the same legal effect. If a student attorney has any question as to whether a refund should be claimed, a protective claim should be filed.
Documents on IRS.gov
- IRS Form 843: Claim for Refund and Request for Abatement
- IRS Form 1040X: Amended U.S. Individual Income Tax Return
- IRS Publication 17: Your Federal Income Tax
- IRC §6402: Authority to make credits or refunds
- IRC §6511: Limitations on Credit or Refund
- IRC §6513: Time Return Deemed Filed and Tax Considered Paid
Resident and Non-Resident Aliens
A resident alien’s income is generally subject to tax in the same manner as a U.S. citizen. A resident alien must report all interest, dividends, wages, or other compensation for services, income from rental property or royalties, and other types of income on the U.S. tax return. These amounts must be reported whether from sources within or outside the United States.
Income of resident aliens is subject to the graduated tax rates that apply to U.S. citizens. Resident aliens use the Tax Table and Tax Rate Schedules which apply to U.S. citizens found in the instructions for Forms 1040, 1040A, or 1040EZ.
Resident aliens can use the same filing statuses available to U.S. citizens.
Resident aliens can claim personal exemptions and exemptions for dependents according to the dependency rules for U.S. citizens. They can claim an exemption for their spouse on a separate return if the spouse had no gross income for U.S. tax purposes and was not the dependent of another taxpayer. They can claim this exemption even if the spouse has not been a resident alien for a full tax year or is an alien who has not come to the United States. They can claim an exemption for each person who qualifies as a dependent according to the rules for U.S. citizens. The dependent must be a citizen or national of the United States or be a resident of the United States, Canada, or Mexico for some part of the calendar year in which the tax year begins. Get Publication 501, Exemptions, Standard Deduction, and Filing Information for more information.
The spouse and each dependent must have either a Social Security Number or an Individual Tax Identification Number in order to be claimed as an exemption or a dependent.
Resident aliens can claim the same itemized deductions as U.S. citizens, using Schedule A of Form 1040. These deductions include certain medical and dental expenses, state and local income taxes, real estate taxes, interest they paid on a home mortgage, charitable contributions, casualty and theft losses, and miscellaneous deductions.
If deductions are not itemized, they can claim the standard deduction for their particular filing status. For further information, see Form 1040 and its instructions.
Resident aliens generally claim tax credits and report tax payments, including withholding, using the same rules that apply to U.S. citizens. The following items are some of the credits they may be able to claim: child and dependent care credit, credit for the elderly and disabled, child tax credit, education credits, foreign tax credit, earned income credit, and adoption credit.
Which Form to File
Non-resident aliens who are required to file an income tax return should use Form 1040NR or, if qualified, Form 1040NR-EZ. Refer to the Instructions for Form 1040NR-EZ to determine if they may use Form 1040NR-EZ. If they do not qualify to file Form 1040NR-EZ, they must file Form 1040NR.
A non-resident alien (NRA) usually is subject to U.S. income tax only on U.S. source income. The general rules for determining U.S. source income that apply to most non-resident aliens are shown below:
|Type of Income||Source Determined By|
|Compensation for Personal Services||Where services are performed|
|Dividends||Type of Corporation (U.S. or foreign)|
|Interest||Residence of payor|
|Rents||Where property is located|
|Royalties-Patents, Copyrights, etc||Where property is used|
|Royalties-Natural Resources||Where property is located|
|Pensions due to personal services performed||Where services were performed while an NRA|
|Scholarships and Fellowships||Generally, residence of payor|
To review detailed discussion of source income, refer to the general rules. See Publication 519, U.S. Tax Guide for Aliens for exceptions to the general rules and additional details.
Note: Not all items of U.S. source income are taxable.
How Income Is Categorized and Taxed
A non-resident alien’s income that is subject to U.S. income tax must be divided into two categories:
- Income that is effectively connected with a trade or business in the United States
- Income that is not effectively connected with a trade or business in the United States
The Difference Between Effectively Connected and Not Effectively Connected Income
The difference between these two categories is that effectively connected income, after allowable deductions, is taxed at graduated rates. These are the same rates that apply to U.S. citizens and residents. Income that is not effectively connected is taxed at a flat 30% (or lower treaty) rate and no deductions are allowed against such income.
A non-resident alien filing Form 1040NR may be able to use one of the filing statuses discussed below. If filing Form 1040NR-EZ, they can only claim “Single non-resident alien” or “Married non-resident alien” as the filing status.
Married Filing Jointly
Generally, the taxpayer cannot file as married filing jointly if either spouse was a non-resident alien at any time during the tax year. However, non-resident aliens married to U.S. citizens or residents can choose to be treated as U.S. residents and file joint returns. For more information on these choices, refer to non-resident Spouse Treated as a Resident in Publication 519.
- A non-resident alien may be eligible to file as a qualifying widow(er) and use the joint return tax rates if:
- They were a resident of Canada, Mexico, Japan, South Korea, or a US national, and:
- Their spouse died in 1999 or 2000 and they have not remarried, and
- They have a dependent child living with them
Note: See the instructions for Form 1040NR for the rules for filing as a qualifying widow(er) with a dependent child.
Head of Household
A non-resident alien cannot file as head of household if they were a non-resident alien at any time during the tax year.
Married Non-resident Aliens Filing Separately
Married non-resident aliens who are not married to US citizens or residents generally must use the Tax Table column or the Tax Rate Schedule for married filing separate returns when determining the tax on income effectively connected with a US trade or business. They normally cannot use the Tax Table column or the Tax Rate Schedule for single individuals.
Generally, if a non-resident alien is engaged in a trade or business in the United States, he or she can claim only one personal exemption. An exemption for a spouse and a dependent may be claimed if the spouse or dependent is described in any of the following categories.
- If a resident of Mexico or Canada or a national of the United States.
- They can also claim a personal exemption for their spouse if the spouse had no gross income for U.S. tax purposes and was not the dependent of another taxpayer. In addition, they can claim exemptions for their dependents who meet certain tests. Residents of Mexico, Canada, or nationals of the United States must use the same rules as US citizens to determine who is a dependent and for which dependents exemptions can be claimed. See Publication 501 for these rules.
Pursuant to tax treaties certain residents of Japan or South Korea and certain students and business apprentices from India may be able to claim exemptions for their spouse and dependents. Refer to IRS Publication 519 for details.
Non-resident aliens cannot claim the standard deduction. However, students and business apprentices from India may be eligible to claim the standard deduction. Refer to Publication 519, U.S. Tax Guide for Aliens for more information.
A non-resident alien can claim deductions to figure their effectively connected taxable income. They generally cannot claim deductions related to income that is not connected with their US business activities. Except for personal exemptions, and certain itemized deductions, a non-resident alien can claim deductions only to the extent they are connected with their effectively connected income. Non-resident aliens can deduct certain itemized deductions if they receive income effectively connected with their US trade or business. These deductions include:
- State and local income taxes,
- Charitable contributions to US organizations,
- Casualty and theft losses,
- Miscellaneous itemized deductions, and
- The ordinary and necessary expenses related to a U.S. trade or business.
Use Schedule A of Form 1040NR to claim itemized deductions. If they are filing Form 1040NR-EZ, they can only claim a deduction for state or local income taxes. If they are claiming any other deduction, they must file Form 1040NR. For a discussion about certain itemized deductions refer to IRS Publication 519.
Adjustments to Gross Income
Non-resident aliens may claim the following adjustments to gross income if they meet the qualifications for each adjustment:
- IRA Deduction
- Student Loan Interest Deduction
- Archer MSA Deduction
- Moving Expenses
- Self-Employed Health Insurance Deduction
- Self-Employed SEP, SIMPLE, and Qualified Plans
- Penalty for early withdrawal of Savings
- Scholarship and Fellowship Grants excluded
Refer to IRS Publication 519 and other IRS Publications for further information.
Education and Earned Income Credits
If they are a non-resident alien for any part of the year, they generally cannot claim the Earned Income Tax Credit, the Hope Credit, or the Lifetime Learning Credit. However, they may claim an adjustment for the student loan interest deduction. Refer to IRS Publication 519 for details.
- Non-resident aliens are not liable to pay self-employment tax.
Social Security Lump Sum Payments
Social Security or disability benefits
Social Security benefits are included in gross income when the taxpayer’s income exceeds a certain level, the base amount. Generally, the income is included in the year it is received. When a person initially applies for Social Security or disability benefits, approval is often delayed for a year or more. In these cases, the first payment may be a lump-sum which exceeds the base amount and generates a tax liability.
Congress has provided an election which may offer relief to taxpayers who receive a lump-sum payment, § 86(e):
LIMITATION ON AMOUNT INCLUDED WHERE TAXPAYER RECEIVES LUMP-SUM PAYMENT. –
- LIMITATION. –If–
- Any portion of a lump-sum payment of Social Security benefits received during the taxable year is attributable to prior taxable years, and
- The taxpayer makes an election under this subsection for the taxable year,
then the amount included in gross income under this section for the taxable year by reason of the receipt of such portion shall not exceed the sum of the increase in gross income under this chapter for prior taxable years which would result solely from taking into account such portion in the taxable years to which it is attributable.
- SPECIAL RULES. –
- YEAR TO WHICH BENEFIT ATTRIBUTABLE. – For purposes of this subsection, a Social Security benefit is attributable to a taxable year if the generally applicable payment date for such benefit occurred during such taxable year.
- ELECTION. – An election under this subsection shall be made at such time and in such manner as the Secretary shall by regulations prescribe. Such election, once made, may be revoked only with the consent of the Secretary.
The Secretary has not prescribed by regulation the time or manner in which an election under this subsection shall be made.
The election allows a taxpayer to relate back the lump-sum payment to the year(s) in which it would have been received. The taxpayer will have gross income for the payment year only to the amount it would have been included in gross income in the prior years (i.e., for each prior year, there is no taxable income from the allocation unless one-half of the allocation plus the taxpayer’s adjusted gross income for the year exceeds the base amount). Because the taxpayer benefits from a separate calculation for each prior year, this election may reduce the amount of tax due. The prior years are not changed by the election, so the client will not need to file amended returns for those years.
IRS Publication 915 (linked below) contains worksheets helpful in determining the amount of taxable income for each year. The Social Security payments are reported on Form SSA-1099. Review the client’s Wage & Income transcripts to determine the amount allocated to each year. You will also need the adjusted gross income for each year. The amounts can usually be obtained by reviewing the Transcript of Return and the Wage & Income Transcript for those years.
Because this is an election made by the taxpayer, the client must file a return for the tax year in which the lump-sum payment is received.
We have provided a sample memorandum addressing lump-sum payments, below.
Repayment of Social Security benefits
Generally, a person who receives Social Security income must include the benefits in the year received. This is true even if the benefits are repaid. However, the Code provides relief for taxpayers who repay benefits received.
Section 86(d)(2)(A) provides:
In general. For purposes of this section, the amount of social security benefits received during any taxable year shall be reduced by any repayment made by the taxpayer during the taxable year of a social security benefit previously received by the taxpayer (whether or not such benefit was received during the taxable year).
This has two possible effects, depending on the timing of the repayment. If repayment occurs in the same year the benefits were received, the taxpayer may deduct the amount of the repayment from the benefits received. If repayment occurs in a year following the receipt of the benefits, the taxpayer may deduct the amount of the repayment from the benefits received in the year of repayment. Note, the deduction is not against the benefits that have been repaid, but against benefits received in the same year as the repayment.
This deduction may be problematic, though, if the taxpayer’s repayment is greater than the total income for the year the repayment occurs. The taxpayer will have excess deductions that cannot be used to offset income. In these circumstances, Code section 1341 provides an alternative option for reclaiming tax paid in a prior year for Social Security benefits that have been repaid in a subsequent year.
There are three requirements for § 1341:
- The benefits must have been included in gross income in a prior year.
- The taxpayer must have “restored” the benefits by making a repayment.
- The repayment must be more than $3,000.
See Andrews v. Commissioner, 1992 T.C. Memo 668 at *4.
The taxpayer must demonstrate that the Social Security benefits were included on a return in a prior year. Gasparutti v. Commissioner, 1998 T.C. Memo 382 at *2.
If the taxpayer meets all three requirements for § 1341, the tax liability for the year of repayment should be calculated without a deduction for the amount of repayment. This tax liability is then reduced by the amount of tax paid on the Social Security benefits in the prior year. I.R.C. § 1341(a)(5). If the prior tax paid is greater than the tax liability for the year of repayment, the taxpayer is entitled to a refund for the excess tax paid. I.R.C. § 1341(b)(1). No adjustment is made to the prior year’s tax return.
Resources on IRS.gov
Self Employment Taxes
Anyone who has net earnings from self-employment of $400.00 or more or any church employee who’s income exceeds $108.28 must pay the SE tax and file Schedule SE (Form 1040).
A taxpayer is considered self-employed if any of the following apply:
- Taxpayer carries on a trade or business as a sole proprietor or an independent contractor.
- Taxpayer is a member of a partnership that carries on a trade or business.
- Taxpayer is otherwise in business for herself
Trade or business
A trade or business is generally an activity carried on for a livelihood or in good faith to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. The regularity of activities and transactions and the production of income are important elements. Taxpayer does not need to actually make a profit to be in a trade or business as long as she has a profit motive. Taxpayer does need, however, to make ongoing efforts to further the interests of his business.
Taxpayer does not have to carry on regular full-time business activities to be self-employed. Having a part-time business in addition to her regular job or business may also be self-employment.
Example: Taxpayer is employed full time as an engineer at the local plant. She fixes televisions and radios during the weekends. She has her own shop, equipment and tools. She gets her customers from advertising and word-of-mouth. She is self-employed as the owner of a part-time repair shop.
Taxpayer is a sole proprietor if she owns an unincorporated business by herself.
People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case. The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to SE tax.
The taxpayer is not an independent contractor if he performs services that can be controlled by an employer (i.e., what will be done and how it will be done). This applies even if he is given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.
If an employer-employee relationship exists (regardless of what the relationship is called), the taxpayer is not an independent contractor and his earnings are generally not subject to SE tax. Rather, the employer is responsible for that portion of the social security and Medicare contributions. However, his earnings as an employee may be subject to SE tax under other rules discussed in this section.
Do not assume that an individual who is treated as an independent contractor is not an employee. Some employers treat individuals as independent contractors instead of employees to avoid being liable for part of the employee’s social security contributions. As a general rule, whether an individual will properly be treated as an independent contractor or as an employee will be influenced by the degree of control that the individual has over the functions he performs to accomplish his assignment.
Other factors also bear on the determination. Because an independent contractor will not have income tax or social security taxes withheld, an independent contractor is responsible for making these tax payments. An individual paid as an independent contractor is often not prepared for the consequences of having to pay taxes herself. This often results in an underpayment for the period in which the individual worked as an independent contractor.
Internal Revenue Code
- IRC §1401, Tax on Self-Employment Income
- IRC §1402, Definitions
- Treas. Reg. §1.1401-1, Tax on self-employment income
- Treas. Reg. §1.1402(a)-1, Definition of net earnings from self-employment
- Treas. Reg. §1.1402(b)-1, Self-employment income
- Treas. Reg. §1.1402(d)-1, Employee and wages
IRS Forms and Publications
Self-Employment-Uber and Lyft Drivers
Please note that this link is being provided solely for its educational value and is not meant to be a referral or endorsement of the H&R Block, which prepared the information, given that the Clinic does not make any referrals to paid preparers. For free tax preparation through a Volunteer Income Tax Assistance (VITA) site, click here.
Trust Fund Recovery
Trust Fund Recovery Penalty
(TFRP or 100% Penalty) – I.R.C. 6672
The trust fund recovery penalty (“TFRP”) is prescribed by IRC § 6672, as section that is used to facilitate the collection of tax and enhance voluntary compliance. It serves as an alternative means of collecting unpaid trust fund taxes when taxes are not fully collectible from the company or business that failed to pay the taxes. Congress enacted IRC § 6672 to encourage prompt payment of withheld and other collected taxes and to ensure the ultimate collection of the taxes from a secondary source. Historically, it is also referred to as the 100% Penalty because the person responsible is liable for 100% of the trust fund withheld amount.
Below is a discussion of the elements developed by both the IRS and courts relating to the factors to consider when determining whether a taxpayer is liable for the TFRP. In a number of instances, the client merely worked in an office and had no authority or responsibility to pay these taxes even though the client may have signed checks. Since each client is unique, we have set out the IRM sections that the IRS Collection and Appeals Officers use in determining liability.
- The TFRP is imposed on any person required to collect, account for, and pay over taxes held in trust who willfully fails to perform any of these activities. The TFRP may be imposed for:
- Willful failure to collect tax,
- Willful failure to account for and pay tax, or
- Willful attempt in any manner to evade or defeat tax or the payment thereof.
- The TFRP is equal to the total amount of tax evaded, not collected, or not accounted for and paid over.
- The TFRP is generally excepted from discharge in bankruptcy because it is entitled to priority status. See 11 U.S.C. 523(a)(1). However, the exceptions to discharge do not apply to Chapter 13 cases filed before October 17, 2005.
- In Chapter 13 cases filed before October 17, 2005, TFRP is dischargeable if it is provided for in the Chapter 13 plan and the debtor successfully completed the plan. For Chapter 13 cases filed on or after October 17, 2005, trust fund recovery penalties are excepted from discharge whether or not they are provided for in the plan or included on a timely proof of claim. See 11 U.S.C. 1329(a) and 523(a)(1). I.R.M 188.8.131.52 (02-08-2011).
- The penalty is equal to the total amount of tax evaded, not collected, or not accounted for and paid over. Assessments of the TFRP are possible based on liabilities for the following tax forms. Generally, the one that clients will be involved with is only the first one. The other forms are:
- 941, Employer’s QUARTERLY Federal Tax Return
- 720, Quarterly Federal Excise Tax Return (see IRM 184.108.40.206.1)
- CT-1, Employer’s Annual Railroad Retirement and Unemployment Return
- 943, Employer’s Annual Federal Tax Return for Agricultural Employees
- 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons
- 945, Annual Return of Withheld Federal Income Tax
- 944, Employer’s ANNUAL Federal Tax Return
- 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests
- 8804, Annual Return for Partnership Withholding Tax (Section 1446)
- TFRP assessments are assessed and designated on the Transcript as “55.”
- The TFRP may be imposed, with respect to the taxes described in the third item listed above for:
- Willful failure to collect tax
- Willful failure to account for and pay over tax
- Willful attempt in any manner to evade or defeat tax or the payment thereof
- A revenue officer is initially responsible for determining liability.
- It is the policy of the IRS that the full unpaid trust fund amount will be collected only once, whether it is collected from the employer/collecting agent, from one or more of its responsible persons, or from a combination of the employer/collecting agent and one or more of its responsible persons.
A “responsible person” is one who has the duty to perform or the power to direct the act of collecting, accounting for, or paying over trust fund taxes. When evaluating responsibility, consider the Supreme Court’s decision in Slodov v. United States, 436 U.S. 238, 78-1, USTC 9447 (1978). Most trust fund recovery penalty cases involve officers of corporations.
However, a responsible person may be one or more of the following:
- an officer or employee of a corporation
- a member or employee of a partnership
- a corporate director or shareholder
- a related controlling corporation
- a lender, a surety, or any other person with sufficient control over funds to direct disbursement of the funds, or
- in some cases, a person assuming control after accrual of the liability.
In each situation, determine who had a duty to ensure that taxes were withheld, collected, or paid over to the government at the specific time the failure occurred. There can be more than one responsible person. See: 220.127.116.11.1 (10-19-2007) Willfulness.
The TFRP is a civil penalty, so the degree of willfulness in failing to collect or pay over any tax leading to liability is not as great as that necessary for criminal proceedings. “Willful” is defined as intentional, deliberate, voluntary, and knowing, as distinguished from accidental. “Willfulness” is the attitude of a responsible person who with free will or choice either intentionally disregards the law or is plainly indifferent to its requirements. The taxpayer must establish that he is not willful. This is accomplished by gathering the facts as to what the taxpayer’s duties and responsibilities were during his or her employment.
Relevant inquiries are:
- Did the person have responsibility and did so willfully to withhold funds as tax and use those funds to pay operating expenses of the business are willful.
- Were the person’s explicit or implicit directions willful to a degree sufficient to make the person liable for the trust fund recovery penalty. The Government does not need to show that a responsible person had any evil intent or desire to defraud the Government of the withheld taxes. The Appeals Officer has responsibility to thoroughly investigate the matter. This is the client’s opportunity to present his or her case in detail. I.R.M. 18.104.22.168.2 (10-19-2007)
- Is the person responsible and if so was the person willful in failing to collect and pay over the trust fund amount. IRM 22.214.171.124.1 (11-12-2010)
To show willfulness, the government generally must demonstrate that a responsible person was aware, or should have been aware, of the outstanding taxes and either intentionally disregarded the law or was plainly indifferent to its requirements. A responsible person’s failure to investigate or correct mismanagement after being notified that withholding taxes have not been paid satisfies the TFRP “willfulness” element. See IRM 126.96.36.199.3, Willfulness, and exhibit 5.7.3-1, Trust Fund Recovery Penalty (TFRP).
It is difficult to establish “willfulness” in the types of assessments shown below:
|The assessment is a Combined Annual Wage Reporting (CAWR) assessment||It is normally difficult to establish willfulness to the degree necessary to assert the TFRP (see exhibit 5.7.3-1 for situations where the TFRP should be pursued).|
|An employment tax assessment is made under IRC 3509||It requires a determination of intentional disregard of the requirements to deduct and withhold taxes (see exhibit 5.7.3-1).|
|The assessment involves a volunteer director or trustee of a tax exempt organization||The Service may need to show the person’s “actual knowledge ” of the organization’s failure to collect or pay over trust fund taxes, if the person was serving as a volunteer solely in an honorary capacity (IRC 6672(e)).188.8.131.52.2 (11-12-2010)|
In the majority of cases, most of the evidence that supports the TFRP will be either business records or bank records. The revenue officer is required to maintain in the file copies of bank records used to establish responsibility and willfulness.
Business records that can be reviewed include:
- Articles of Incorporation; Partnership Agreement; or other documents establishing/forming the business entity
- Minute Books
- Forms 941, Employer’s Quarterly Federal Tax Return; 1120, U.S. Corporate Income Tax Return; 1065 , U.S. Return of Partnership Income; or, 1040, U.S. Individual Income Tax Return (for disregarded LLCs)
- For cases where the employment tax returns were submitted in an electronic format (E-file or TeleFile), the signature information is not available on the printed document since the forms are signed via an IRS issued PIN. Use Form 4844, Request for Terminal Action, to request the specific items below from the appropriate Submission Processing Center. For TeleFile returns, request the “signature document” from the Cincinnati Submission Processing Center (CSPC). For E-File returns, request a “copy of Form 8633” , or if the authorized signer is a Reporting Agent, request a “copy of Form 8655″ from the Andover Submission Processing Center (ANSPC). For On-line returns request a copy of the ” PIN signature receipt” from CSPC.
- Payroll records
- Any other records that may be relevant to determining the roles and responsibilities of individuals involved with the business entity.
Business records will be reviewed to determine:
- Duties (and changes to duties) of officers, directors, etc.
- Appointments and resignations of officers, directors, etc.
- Responsibilities of individuals to file and pay tax returns
- Issuance of stock to officers, directors, etc.
- Assets transferred to officers, directors, etc.
- Loans made to officers, directors, etc.
- Unreported payroll and other taxes
- Diversion of funds
- Borrowing of funds not used to pay taxes
Bank records that can be reviewed include:
- Cancelled checks and bank statements
- Signature cards and correspondence to the bank relative to changes affecting the signature cards
- Loan applications and records of loans
- Any other records that may be relevant to determining which individuals were involved in the financial affairs of the business
The bank records will be reviewed to determine:
- Authority of persons to sign checks and deposit funds
- Authority of persons to obligate the business by borrowing
- Diversion of funds to officers, members, etc.
- Deposits and withdrawals of alleged loans to business by officers, members, directors, etc.
- Excessive salaries, expenses, etc.
- Payment of other obligations
- Deposit records for monies received for sale of assets
- Deposit records of payments for stock, membership, or other ownership rights in the business
- Any other relevant records
Establishing Responsibility Responsibility is a matter of status, duty, and authority. A determination of responsibility is dependent on the facts and circumstances of each case.
Potential responsible persons include:
- Officer or employee of a corporation
- Partner or employee of a partnership
- Corporate director or shareholder
- Another corporation
- Employee of a sole proprietorship
- Limited liability company (LLC) member, manager or employee
- Surety lender
- Other person or entity outside the delinquent business organization
A responsible person has:
- Duty to perform
- Power to direct the act of collecting trust fund taxes
- Accountability for and authority to pay trust fund taxes
- Authority to determine which creditors will or will not be paid
To determine whether a person has the status, duty and authority to ensure that the trust fund taxes are paid, consider the duties of the officers as set forth in the corporate by-laws as well as the ability of the individual(s) to sign checks.
In addition, determine the identity of the individuals who:
- Are officers, directors, or shareholders of the corporation
- Hire and fire employees
- Exercise authority to determine which creditors to pay
- Sign and file the excise tax or employment tax returns, such as Form 941, Employer’s Quarterly Federal Tax Return
- Control payroll/disbursements
- Control the corporation’s voting stock
The indicators of responsibility include the following however merely having the indicator does not make the individual responsible for withholding.
- The full scope of authority and responsibility is contingent upon whether the person had the ability to exercise independent judgment with respect to the financial affairs of the business.
- If a person is an officer or owns stock in the corporation, this cannot be the sole basis for a responsibility determination.
- If a person has the authority to sign checks, the exercise of that authority does not, in and of itself, establish responsibility. Signatory authority may be merely a convenience.
- Persons with ultimate authority over financial affairs may generally not avoid responsibility by delegating that authority to someone else. If a potentially responsible person asserts that the duty to pay taxes or otherwise handle the financial affairs of the business was delegated to an employee:
- Evaluate the facts and circumstances of the case
- Determine whether the delegation rendered the person (delegator) powerless to disburse funds or dictate fiscal policy. Delegation may be relevant when determining willfulness.
- Persons serving as volunteers solely in an honorary capacity as directors and trustees of tax exempt organizations will generally not be considered responsible persons unless they participated in the day-to-day or financial operations of the organization and they had actual knowledge of the failure to withhold or pay over the trust fund taxes. This does not apply if it would result in there being no person responsible for the TFRP. Refer to IRC § 6672(e). I.R.M. 184.108.40.206.1.1 (04-13-2006)
Policy Statement P-5–14 (IRM 220.127.116.11.3) states that individuals performing ministerial acts without exercising independent judgment will not be deemed responsible. In general, non-owner employees who act solely under the dominion and control of others, and who are not in a position to make independent decisions on behalf of the business entity, will not be assessed the TFRP. Non-owner employees are those who do not own any stock, interest, or other entrepreneurial stake in the company that employs them.
- Ministerial acts are performed under the supervision of someone else and do not require independent judgment or decision-making ability.
The bookkeeper of a company is not an owner and is not related to an owner. She has check signing authority and she pays all of the bills that the treasurer gives her. She is not permitted to pay any other bills, and when there are not sufficient funds in the bank account to pay all of the bills, she must ask the treasurer which bills to pay. The bookkeeper is performing a ministerial act and should generally not be held responsible for the TFRP.
- A person is “responsible” for purposes of the TFRP if that person has “significant control” over the company’s finances. “Significant control” means more than having the mere mechanical duty of signing checks or preparing tax returns or having a title that appears to have authority. However, a responsible person need not have the final word in the company regarding the payment of creditors. Officers and higher level employees of a company who are non-owners may still be required to sacrifice their jobs (i.e., quit) to avoid being responsible for the TFRP, rather than obey the orders of an owner to pay other creditors but not to pay current federal trust fund taxes as they become due. See Brounstein v. United States, 979 F.2d 952, 956 (3rd Cir. 1992).
- A non-owner employee is generally not a “responsible person ” if the employee’s function was solely to pay the bills as directed by a superior, rather than to determine which creditors would or would not be paid. However, if a non-owner employee, such as an officer, has significant control over making the company’s other financial decisions about who to pay or has the ability to obtain financing for the company, then such an employee cannot avoid being responsible for the TFRP by merely showing that an owner or a lender limited his discretion on the specific matter of paying taxes that the company owed.
A non-owner employee works as a clerical secretary in the office. She signs checks and tax returns at the direction of and for the convenience of the owner or a supervisor who is a non-owner. She is directed to pay other vendors, even though payroll taxes are unpaid. The secretary is not a responsible person for the TFRP because she works under the dominion and control of the owner or of a supervisor who is a non-owner and she is not permitted to exercise independent judgment.
The long-time controller of a company was never a shareholder, director, or officer of the company, but he was responsible for overseeing the finances of the company, including the preparation of the payroll and filing the company’s federal employment tax returns. He had the authority to sign checks in any amount and he dealt with the company’s lender on a regular basis when the company experienced financial troubles, though he did not arrange or sign the lending agreement on the company’s behalf. When the lender directed the company to pursue an orderly liquidation of its assets, the controller requested funds from the lender to make full payroll and pay the taxes due on the remaining employees, but the lender forwarded only enough funds for the company to make net payrolls. The controller made out net payroll checks to the remaining employees and paid none of the taxes due, rather than prorate the funds available to the company between payroll and taxes. The controller could be a responsible person for the TFRP. See Hochstein v. United States, 900 F.2d 543 (2nd Cir. 1990).
An experienced businessman was never a shareholder, director, or officer of a new company, but he served as the general manager of the new company during a seven month period. As general manager, he signed most of the company’s checks to creditors, as well as signing net payroll checks to employees, and there was no monetary limit placed on his check signing authority. He told the bookkeeper which bills to pay. When the company was experiencing cash flow problems, he spoke to one of the owners about the company’s delinquent payroll taxes. The owner told the general manager that these unpaid taxes were none of the general manager’s business and he should not worry about paying the company’s net payroll and missing its tax payments. Both the general manager and the owner believed that the general manager could not be held liable for the TFRP because he was not an owner or officer of the company; the general manager turned down an offer to become the company’s president specifically because he was worried about the company’s tax situation. The general manager could be a responsible person for the TFRP. See Gephardt v. United States , 818 F.2d 469 (6th Cir. 1987). I.R.M. 18.104.22.168.1.2 (11-12-2010)
Below is a brief discussion of the responsibilities of the Revenue Officer and Appeals Officer under IRM 22.214.171.124.1 (2-8-2011) and 126.96.36.199 (10-19-2007).
The Collection function has sole responsibility for recommending assertion of the trust fund recovery penalty. Examination function personnel may refer potential trust fund recovery penalty cases to Collection for investigation. For additional information, see IRM 5.7, Trust Fund Compliance. Before a Trust Fund Recovery Penalty is assessed, taxpayers are mailed or hand delivered a 60-Day Notice of Proposed Assessment, Letter 1153. Letter 1153 advises taxpayers of the proposed penalty and of their appeal rights.
- If the taxpayer agrees with the proposed penalty, he/she will return a signed Form 2751, Proposed Assessment of the Trust Fund Recovery Penalty.
- If the taxpayer disagrees, he/she may discuss the proposed penalty with the revenue officer’s group manager or file a written protest.
The taxpayer has 60 days in which to file a timely protest (75 if the letter was addressed outside of the United States). A protest is considered timely if it is mailed on or before the 60th day, (or 75th if outside of the United States) i.e., timely mailed is timely filed. The 60 day period is measured from the mailing date of the Letter 1153, or from the delivery date if Letter 1153 is delivered in person. A timely mailed protest is still timely for purposes of IRC 6672(b)(3)(B) even if the protest is inadequate. Most trust fund recovery penalty cases that are considered by Appeals are pre-assessment. Appeals may receive post assessment trust fund recovery penalty claim cases also.
If the taxpayer timely protests a proposed TFRP, the assessment period will be extended until the date that is 30 days after Appeals makes its final determination with respect to the protest. A protest is timely if it is mailed on or before the 60th day (75th day if the letter was addressed outside the United States) after the mailing or personal delivery of Letter 1153. This gives the taxpayer a full 60 days (75 days if the letter was addressed outside the United States) to respond to Letter 1153. Collection is expected to wait until the 65th day to make any assessment to allow for mail time of a protest.
Appeals is the sole function that may make the “final administrative determination” for purposes of IRC 6672(b)(3)(B). To ensure that the statute is protected on these cases, Appeals will not release jurisdiction before the case is resolved, e.g. Appeals will not release jurisdiction on premature referrals. If Appeals needs to retain jurisdiction, prepare an Appeals Referral Investigation (ARI), for further development or some other reason. Collection should take the necessary action in 45 days. This 45 day period can be extended through mutual agreement of both functions.
After filing a timely protest with Collection, a taxpayer will have 30 days, or any longer period if Collection agrees, to perfect any defects in the protest. After the end of 30 days (or any longer period agreed to), the taxpayer’s case is to be sent to Appeals even if it is imperfect. Appeals will give the taxpayer an opportunity to provide any missing information. This is to ensure that any taxpayer who wishes to appeal will have the opportunity to do so.
IRC 6103(e)(9) provides for disclosure of information where more than one person is held liable for the trust fund recovery penalty. Once a person is determined to be liable then, upon their written request, the Service may disclose, in writing, the name of any other person determined to be liable, whether the Service has attempted to collect the penalty from the other liable person, the general nature of the collection activities and the amount collected. A person is determined to be liable for purposes of IRC 6103(e)(9) when that person is assessed. Therefore, no disclosure is permitted until after the person is assessed.
Following the above points and check lists will assist the student attorney in determining whether the client is responsible and willful and thus liable for the tax.