Are you considered an innocent spouse for tax purposes? What is an innocent spouse and is there a protection for innocent spouses?

Most couples file joint income tax returns as a married couple. This means generally that both parties are responsible for what is on the return, as well as what income should be reflected on the return, but is not. Sometimes the division of labor between husband and wife is such that one of the parties handles the tax return. Sometimes that person places the returns in front of the non-preparing spouse and that spouse signs the returns, not knowing or checking the information in the returns for accuracy. Worse still are cases where the preparing spouse signs both names to the returns and the non-preparing spouse has no clue that the return was ever prepared, filed or what was in the return.

As a result, if the preparing spouse prepares the returns and substantially underreports the income earned, both parties are responsible for the additional tax, interest and penalties that ensue because of the action of the one spouse. Sometimes the unreported income is a result of fraud, gambling, drugs or other illicit activities. The non-preparing spouse may claim that he or she did not have any knowledge of the underreporting and they may genuinely not have any knowledge, but still may be held responsible by the IRS.

There is a procedure to request “innocent spouse” relief from the IRS, which involves filing an IRS Form 8857, which form needs to be filed within two years from the date that the IRS files a levy notice for the tax owed. A person who needs to use this form and request this relief should go to a qualified professional, as certain documents should be attached to the form. The IRS has denied about 2,000 of the 50,000 taxpayers that apply for relief each year, just for filing for this relief after the two year period has elapsed.

While the federal lawmakers are pushing for rule changes for the innocent spouse rule, it is important if the usual non-preparing spouse suspects their partner of failing to include income or making up expenses, that non-preparing spouse should file a separate return. That way that spouse will not be liable for the tax mess created by the other spouse.

Another thing that people may not know is that the IRS can legally disregard a divorce decree. Even if that decree holds you harmless or states that the other party is responsible for the IRS problems, the IRS does not have to follow that provision. That just means that if the IRS comes after you for the entire amount and your former spouse has any assets, you may go after him or her to recover the amount pursuant to that section of the decree. At that point, though, that former spouse probably has no assets to recover or even to pay the IRS their due.

Sometimes an abusive relationship keeps one spouse from taking action or filing a separate return. If this happens, it is recommended that spouse keep a diary or other record to support their fears, which may come in handy later.

Although the IRS will allow the innocent spouse rule to protect some spouses, it is always a better route not to have to trust that they will. If in doubt, file a separate return.

About two years ago, an new law was enacted which provided for the formation of Low-Profit Limited Liability Companies, referred to as L3C’s. These entities are organized to do good for a charitable purpose, but are still formed to be for-profit entities. Since these are organized as a for-profit entity, these organizations can attract the capital that is necessary for their purposes without relying on grants or other charitable contributions.

These are vehicles which can offer more flexible, leveraged solutions to complex problems in our society. For instance, if a private foundation wanted to operate a training program for residents in an economically depressed neighborhood, the L3C could open a laundry in that neighborhood, the private foundation could do the training. A normal for-profit company might be unwilling to take the entire risk, so a private foundation can do a joint venture with the L3C to further the charitable purposes of the private foundation.

L3C’s are intended to make it possible for both the tax-exempt private foundation and for profit entities to invest in a way that significantly furthers one or more charitable or educational purposes. Both tax-exempt and for-profit companies can invest in and be members of an L3C. As with a regular LLC, the L3C can be managed by one or more of its members or by an outside manager.

A big advantage for a private foundation is that the investment in the L3C is intended to qualify as a program related investment under the Internal Revenue Code, although the IRS has failed to either recognize the L3C entity or provide a procedure for determining if the investment in an L3C is considered program related. Once the IRS formally recognizes these vehicles, it will be easier to use the L3C. Until then, a private foundation will have to file to obtain a private letter ruling for each program related investment made by a private foundation, which can be time consuming and costly.

This new entity may offer new options for achieving a charitable purpose in the future to help solve many of the problems in our society.