When It's Better to Be in Bed with the IRS

So often we encounter clients who live above their means. To finance their spending in excess of income, parties may use credit cards, take out a home equity line of credit on their home, borrow against life insurance policies and/or make early withdrawals from their retirement accounts. These individuals generally pay off their marital debt with a portion of the proceeds from the sale of the marital home. But what happens when the client and his or her spouse have been living above their means by failing to file their federal and state income taxes?

Interest and Penalties

As we all know, the interest and penalties associated with one's failure to file federal and state income tax returns can be astronomical. Many times, the interest and penalties, coupled with the amount of tax due, totals more than the equity in the marital home. If you have, or have had, a case like this, you know that a settlement is next to impossible. The reason settlement is unlikely is that one party will most likely claim “innocent spouse,” hoping that his/her soon-to-be ex will be forced to shoulder all the tax debt. But what if both parties knew they were not in full compliance with their federal and state taxes? What if the parties intentionally had one party file “married filing separately” (the spouse that earned the lower income) in hopes that doing so would enable them to obtain credit and fly under the radar of the Internal Revenue Service (IRS)?

The Best-Laid Plans '

Believe it or not, the above scenario is not uncommon. The plan works great when the parties are happily married, but things get very sticky once when the party who filed the income taxes then files for divorce. The spouse who filed his/her federal and state income tax returns will most likely claim that he or she had absolutely no idea that their husband or wife had not filed their income taxes. They may claim that they chose to file “married filing separately” because they thought their spouse was engaging in “funny stuff” with his/her business and did not want to have any part of it. Clearly, the party who failed to file the returns will have to become compliant now he/she is immersed in the judicial system. But because the one spouse already filed “married filing separately,” the spouse who did not file an income tax return cannot now request that his spouse amend the returns to a joint filing status. The IRS does not permit such an amendment. Thus, the spouse who has not filed income tax returns in all these years is going to be stuck paying much more in taxes because he or she is going to have to file “married filing separately.” Also, if the spouse that filed the returns did not itemize, the spouse who failed to file will not be permitted to itemize, which will result in a large tax obligation. This equates to more money in interest and penalties.

Advice for Counsel

The first thing the non-filing party's counsel wants to do is have his/her client retain an accountant or tax attorney familiar with handling these types of matters. It is also important that the attorney is comfortable with the accountant or tax attorney because s/he will have to work closely with him. Next, the accountant or tax attorney must prepare the delinquent returns and assess all the penalties and interest the client is facing. Once that is complete, the accountant or tax attorney must review the returns filed by the non-filing party's spouse and prepare a chart showing the financial difference between the parties filing “married filing jointly” and “married filing separately.” Next, the accountant or tax attorney should contact the IRS in an attempt to bring the non-filing client into compliance without any criminal penalties. Clearly, the fact that the non-filing spouse is claiming that s/he intentionally did not file could be a serious criminal issue.

However, a long-standing practice of the IRS has been not to recommend criminal prosecution of individuals for failure to file tax returns, provided they voluntarily file, or make arrangements to file, before being notified they are under criminal investigation.

The Next Step

Once the accountant or tax attorney contacts the IRS, he or she should begin to negotiate with the IRS regarding an abatement of interest and penalties. Of course, the attorney will also want the accountant or tax attorney to contact a representative from the state in which the party is required to file taxes. Frequently, the focus on federal income tax returns leads to neglect of the state income tax returns. The attorney should make sure that does not happen. Once the final amount owed in taxes, interest and penalties to both the federal and state government is determined, the attorney can then begin negotiating with opposing counsel with regard to the filing party's contribution toward the back taxes, interest and penalties.

However, before negotiating with opposing counsel, it is essential to know exactly what transpired between the two clients during the years that one spouse filed and the other did not. For example, did the party who filed prepare his/her own return or did s/he use an accountant? If the filing party used an accountant, did the parties see the accountant together? Who paid the accountant's bill? Did the filing party claim all of the parties' children as dependants? If not, why? Did the filing party file an itemized return? If not, why? Also, the non-filing spouse needs to know exactly when the filing spouse filed his or her returns. It may turn out that s/he filed several years of returns simultaneous with the divorce action. This is all critical information because if it is clear that the parties were essentially conspiring, the more leverage the filing spouse will have when negotiating or presenting the case at trial.

Conclusion

That fact of the matter is that early intervention with the IRS is key to the case. Due to the level of speed in which the IRS moves, a trial court may not wait around for the IRS to determine the final amount owed in taxes, interest and penalties. If that happens, the attorney may be forced to try or settle his/her case without knowing the full amount of the liability.

Laurence J. Cutler, a member of this newsletter's Board of Editors, is an equity partner with Fox Rothschild, LLP in Roseland, NJ. Erin D. DeGeorge is a senior associate with the firm.

So often we encounter clients who live above their means. To finance their spending in excess of income, parties may use credit cards, take out a home equity line of credit on their home, borrow against life insurance policies and/or make early withdrawals from their retirement accounts. These individuals generally pay off their marital debt with a portion of the proceeds from the sale of the marital home. But what happens when the client and his or her spouse have been living above their means by failing to file their federal and state income taxes?

Interest and Penalties

As we all know, the interest and penalties associated with one's failure to file federal and state income tax returns can be astronomical. Many times, the interest and penalties, coupled with the amount of tax due, totals more than the equity in the marital home. If you have, or have had, a case like this, you know that a settlement is next to impossible. The reason settlement is unlikely is that one party will most likely claim “innocent spouse,” hoping that his/her soon-to-be ex will be forced to shoulder all the tax debt. But what if both parties knew they were not in full compliance with their federal and state taxes? What if the parties intentionally had one party file “married filing separately” (the spouse that earned the lower income) in hopes that doing so would enable them to obtain credit and fly under the radar of the Internal Revenue Service (IRS)?

The Best-Laid Plans '

Believe it or not, the above scenario is not uncommon. The plan works great when the parties are happily married, but things get very sticky once when the party who filed the income taxes then files for divorce. The spouse who filed his/her federal and state income tax returns will most likely claim that he or she had absolutely no idea that their husband or wife had not filed their income taxes. They may claim that they chose to file “married filing separately” because they thought their spouse was engaging in “funny stuff” with his/her business and did not want to have any part of it. Clearly, the party who failed to file the returns will have to become compliant now he/she is immersed in the judicial system. But because the one spouse already filed “married filing separately,” the spouse who did not file an income tax return cannot now request that his spouse amend the returns to a joint filing status. The IRS does not permit such an amendment. Thus, the spouse who has not filed income tax returns in all these years is going to be stuck paying much more in taxes because he or she is going to have to file “married filing separately.” Also, if the spouse that filed the returns did not itemize, the spouse who failed to file will not be permitted to itemize, which will result in a large tax obligation. This equates to more money in interest and penalties.

Advice for Counsel

The first thing the non-filing party's counsel wants to do is have his/her client retain an accountant or tax attorney familiar with handling these types of matters. It is also important that the attorney is comfortable with the accountant or tax attorney because s/he will have to work closely with him. Next, the accountant or tax attorney must prepare the delinquent returns and assess all the penalties and interest the client is facing. Once that is complete, the accountant or tax attorney must review the returns filed by the non-filing party's spouse and prepare a chart showing the financial difference between the parties filing “married filing jointly” and “married filing separately.” Next, the accountant or tax attorney should contact the IRS in an attempt to bring the non-filing client into compliance without any criminal penalties. Clearly, the fact that the non-filing spouse is claiming that s/he intentionally did not file could be a serious criminal issue.

However, a long-standing practice of the IRS has been not to recommend criminal prosecution of individuals for failure to file tax returns, provided they voluntarily file, or make arrangements to file, before being notified they are under criminal investigation.

The Next Step

Once the accountant or tax attorney contacts the IRS, he or she should begin to negotiate with the IRS regarding an abatement of interest and penalties. Of course, the attorney will also want the accountant or tax attorney to contact a representative from the state in which the party is required to file taxes. Frequently, the focus on federal income tax returns leads to neglect of the state income tax returns. The attorney should make sure that does not happen. Once the final amount owed in taxes, interest and penalties to both the federal and state government is determined, the attorney can then begin negotiating with opposing counsel with regard to the filing party's contribution toward the back taxes, interest and penalties.

However, before negotiating with opposing counsel, it is essential to know exactly what transpired between the two clients during the years that one spouse filed and the other did not. For example, did the party who filed prepare his/her own return or did s/he use an accountant? If the filing party used an accountant, did the parties see the accountant together? Who paid the accountant's bill? Did the filing party claim all of the parties' children as dependants? If not, why? Did the filing party file an itemized return? If not, why? Also, the non-filing spouse needs to know exactly when the filing spouse filed his or her returns. It may turn out that s/he filed several years of returns simultaneous with the divorce action. This is all critical information because if it is clear that the parties were essentially conspiring, the more leverage the filing spouse will have when negotiating or presenting the case at trial.

Conclusion

That fact of the matter is that early intervention with the IRS is key to the case. Due to the level of speed in which the IRS moves, a trial court may not wait around for the IRS to determine the final amount owed in taxes, interest and penalties. If that happens, the attorney may be forced to try or settle his/her case without knowing the full amount of the liability.

Laurence J. Cutler, a member of this newsletter's Board of Editors, is an equity partner with Fox Rothschild, LLP in Roseland, NJ. Erin D. DeGeorge is a senior associate with the firm.