Should You Consider Filing Separately from Your Spouse?
Generally, with regard to the amount of tax paid, it works out favorably for most married taxpayers to file jointly, or together with their spouse. Filing jointly involves reporting the income and deductions of both spouses on the same return. But married taxpayers have another option, they have the option of filing separately from their spouse.
While there are several “marriage penalties” that exist under the Internal Revenue Code, which may result in married taxpayers having an increased tax burden as compared with single taxpayers, that is not the focus of this article. Rather, the discussion is focused on whether you should file separately from your spouse to avoid “joint and several liability” for the tax return filing.
What is Joint and Several Liability?
Joint and several liability is the legal concept that a creditor or plaintiff looking to sue multiple parties can, at the creditor or plaintiff’s discretion, pursue both parties together (joint liability) or either party separately (several liability) for the full amount of the debt. Joint and several liability is applicable to spouses who file taxes using the “Married Filing Jointly” filing status. So, if you are a married taxpayer who files jointly with your spouse (which is typical for most married couples) you could potentially be on the hook for any tax resulting from underreported income attributed to your spouse. Here is an example:
Bob and Melissa are married (or Bob and Steve, or Melissa and Rachel, as same sex married couples now have equal rights under the tax laws). Bob is a self-employed mechanic with three employees. Bob’s business generates very good revenue; however, he oftentimes has difficulties with record-keeping, meeting payroll, and making estimated tax payments. Melissa is a doctor who is employed full-time at a local hospital. She claims zero exemptions on her Form W-4 and generally pays in more withholding tax than what would represent her individual tax liability. Bob and Melissa always file jointly (you can probably guess where this example is going).
Bob is busy running the business and forgets to make his estimated tax payments. Seeing the cash in the bank, he decides to use it to treat himself to a new sports car (no doubt to reward himself for working so hard). Because of Bob’s failure to make estimated tax payments which would cover his share of the couple’s tax liability, when Bob and Melissa file taxes they unexpectedly owe $40,000. Additionally, Bob receives a tax notice that the IRS will be auditing his business income and expenses reported on his Schedule C for the previous tax year. We will assume for the purposes of this example that the audit is resolved quickly, which is rare, but at the end of the audit, the IRS issues a notice of deficiency for $60,000 due to Bob’s poor recordkeeping and inability to substantiate his deductions (also Bob opted to represent himself in the case).
If you were the creditor in this scenario, who do you think is the best spouse to collect from? Yes, Melissa. Even though the debt is not attributable to her actions, because she filed jointly with her spouse, she is liable to the IRS for the entire $100,000 of the debt, and seeing a good source for collection, the IRS could potentially garnish her wages to collect on the couple’s joint tax debt. If this result seems unfair, that is because it is unfair. There are some potential remedies that might be available to Melissa, but it would involve delving deeply into the facts and circumstances of her and Bob’s situation. However, what she likely should do going forward is file “Married Filing Separately” to avoid being held liable for Bob’s tax debt that has the potential to accumulate as the years pass, without changes in his behavior.
Indicators That You May Want to File Separately
Filing separately does come at a cost. Many tax credits are not available for taxpayers who file “Married Filing Separately”, it may eliminate your ability to take the standard deduction (if your spouse itemizes deductions), and it may result in less favorable tax brackets. However, there are circumstances where despite the tax consequences, it may be better to file separately to avoid joint and several liability for your spouse’s tax debt. I am ignoring community property considerations to avoid making this article too lengthy, but keep in mind that in community property states, this analysis would be different.
Financially Irresponsible Spouse with Significant Income
Sometimes, even in the best of marriages, one spouse may be more financially responsible than the other. If the spouse who is less financially responsible has no income to report on the tax return, there is probably little risk to filing jointly. But if the financially irresponsible spouse has significant income to report, as in the previous example with Bob and Melissa, this could have drastic consequences for the financially responsible spouse. If Bob and Melissa later divorce, the IRS generally is not going to care that it was Bob’s fault, they just want their money—and they will get it by any legal means that they can.
Spouse with Addiction
If one spouse is dealing with an addiction (such as gambling, drugs, alcohol, etc.), this results in the spouse not having full control of his or her actions. As a result, the spouse dealing with an addiction may commit illegal acts to fund his or her addiction (commonly embezzlement), fraudulently claim refunds on the tax return, fail to file returns due to inability to focus on obligations, fail to pay scheduled tax payments, or other unfortunate consequences. If one spouse does not have control of his or her actions, it is probably not a good idea to be exposed to joint and several liability by filing jointly with him or her.
If it is known to you that your spouse is committing illegal activities, it is not a good idea to file jointly. People who commit illegal activities generally do not report the proceeds of such activities on their taxes. Filing jointly with a spouse who has such known unreported income can result in tax liability for you, even if you are not participating in the illegal activity yourself.
Maintaining Separate Property
In certain states, by filing separately, it enables each spouse to have a record that tracks and supports their separate income and assets during the marriage. This can be especially useful when one or both spouses have significant income or assets. In the event of a divorce, this separate tracking of income may support the terms within a prenuptial agreement that awards each spouse their separate income and assets.
What Remedies May Be Available to Prevent Unfair Results?
I mentioned earlier in the article that there were potential remedies available to Melissa, and she should definitely consult a taxpayer representative, preferably an Attorney in her case, to explore them. The remedies available to her will be based on her individual facts and circumstances.
Here is a quick rundown of two remedies that may be available to a taxpayer who is, or may potentially be, held liable for the tax debt of his or her spouse.
Injured Spouse Allocation (Form 8379)
If a taxpayer wishes to file jointly with his or her spouse but the spouse has unpaid child support, student loans, state tax debt, etc., to avoid having the non-liable spouse’s share of the refund confiscated by the creditor, the non-liable spouse can file an Injured Spouse Allocation form with the IRS. This form allocates all income and deductions to each respective spouse and prevents the non-liable spouse’s share of the refund from going to a debt for which he or she is not responsible.
Innocent Spouse Relief (Form 8857)
If a taxpayer believes that his or her spouse should be fully responsible for the tax debt for which they are both jointly and severally liable, the taxpayer can apply for innocent spouse relief with the IRS. The form required to request relief is quite extensive, and requires disclosing details of your marriage, your financial situation, education level, and a multitude of other factors. When the IRS already has you on the hook with joint and several liability, there is an incentive for them not to “catch and release”. It takes very strong evidence and a particularly unfair impact to qualify for innocent spouse relief. However, with the right set of facts, and particularly with the assistance of a taxpayer representative, this relief may be available. There are three options for innocent spouse relief:
- Relief of Liability– This type of relief allows the innocent spouse to be completely relieved of all tax, penalties, and interest if the responsible spouse improperly reported items or omitted items from the jointly filed tax return. With this type of relief, you must prove to the IRS’s satisfaction that at the time you filed the return with your spouse you did not know, or have reason to know, that there was an understatement of tax and thus it would be unfair to hold you liable.
- Relief by Separation of Liability– This type of relief would allow the spouses to allocate the tax and its related penalties and interest by party, with each spouse responsible for only his or her own share. To qualify for this type of relief, you must either be divorced or separated from your spouse or you must not have been a member of the same household during the 12-month period preceding your filing of the request.
- Equitable Relief– This type of relief is available if neither of the previous situations apply, but for public policy reasons the innocent spouse should be relieved of responsibility. There are several conditions that must be met to qualify for this relief, and essentially you will not qualify for equitable relief if you have “unclean hands”. Any indications of an intent to commit fraud in the filing, transferring of assets, or otherwise with respect to the taxpayer’s situation or request will result in a denial of relief.
The clever among you may be thinking, “Can I amend my return to file separately once it is determined that my spouse has unreported income and is now an IRS target?”. The unfortunate answer to this question is no. Once you are both on the hook by filing jointly, the IRS certainly does not want to let one of you off without making it as difficult as possible for you to obtain that release. They have two people they can collect from instead of one—a dream scenario. Could this be why there are so many incentives to file jointly under the Internal Revenue Code? Probably so!
If you would like to discuss your situation to determine whether you should consider filing separately from your spouse, or if you are currently being held responsible for your spouse’s (or former spouse’s) tax debt, feel free to contact me using the form below.