In A New Jersey Divorce, Who Is Responsible For Outstanding State and Federal Taxes?
Taxes are often a dreaded topic of conversation for most people. Whether it be yearly taxes that have to be paid or an exorbitant amount of back taxes owed, neither the Internal Revenue Service (IRS) nor the state of New Jersey’s Division of Taxation are entities that one wants after them. An interesting issue in a divorce case that one of our law firm’s attorneys is handling involves the effect that outstanding tax debt due to the Internal Revenue Service and the state of New Jersey may have on the settlement. Both lawyers in this hotly contested divorce are arguing about who should be responsible for the outstanding tax lien. Many times, allocation of tax debt directly effects the division of marital assets.
I will first address outstanding tax debt that accumulates during the marriage. Clients should be aware that when they are signing a tax return with their spouse they are essentially agreeing to be liable for the taxes that are owed in conjunction with that return. It is presumed that one would not sign a return if they did not have full knowledge as to what they are signing. While in theory this may make sense, in practice I experience quite the opposite. I have had countless clients state that they had no idea what a spouse was doing in terms of their income and that they had no idea of the tax liabilities they faced, that is until the divorce was already in progress. What to do? If you feel like you have been kept in the dark regarding the outstanding taxes you and your spouse owe and you believe the debt was acquired solely because of your spouse’s actions you may have the option to file for what is called “innocent spouse relief” with the IRS.
In most cases, when filing jointly, both taxpayers are jointly and severally liable for the tax and any additions to tax, interest or penalties that arise from the joint return even if they later divorce. Joint and several liability means that each taxpayer is legally responsible for the entire liability. Thus, both spouses on a married filing jointly return are generally held responsible for all the tax due even if one spouse earned all the income or claimed improper deductions or credits. This is also true even if a divorce decree states that a former spouse will be responsible for any amounts due on previously filed joint returns. In some cases, however, a spouse can get relief from joint and several liability.
There are three types of relief from joint and several liability for spouses who filed joint returns:
1. Innocent Spouse Relief provides you relief from additional tax you owe if your spouse or former spouse failed to report income, reported income improperly or claimed improper deductions or credits.
2. Separation of Liability Relief provides for the allocation of additional tax owed between you and your former spouse or your current spouse from whom you are separated when an item was not reported properly on a joint return. The tax allocated to you is the amount for which you are responsible.
3. Equitable Relief may apply when you do not qualify for innocent spouse relief or separation of liability relief for something not reported properly on a joint return and generally attributable to your spouse. You may also qualify for equitable relief if the amount of tax reported is correct on your joint return but the tax was not paid with the return.
You must request innocent spouse relief or separation of liability relief no later than 2 years after the date the IRS first attempted to collect the tax from you. For equitable relief, you must request relief during the period of time the IRS can collect the tax from you. If you are looking for a refund of tax you paid, then you must request it within the statute period for seeking a refund, which is generally three years after the date the return is filed or two years following the payment of the tax, whichever is later.
You must meet all of the following conditions to qualify for innocent spouse relief:
- You filed a joint return that has an understatement of tax (deficiency) that is solely attributable to your spouse's erroneous item. An erroneous item includes income received by your spouse but omitted from the joint return. Deductions, credits and property basis are also erroneous items if they are incorrectly reported on the joint return
- You establish that at the time you signed the joint return you did not know, and had no reason to know, that there was an understatement of tax and
- Taking into account all the facts and circumstances, it would be unfair to hold you liable for the understatement of tax
To qualify for separation of liability relief, you must have filed a joint return and must meet one of the following requirements at the time you request relief:
- You are divorced or legally separated from the spouse with whom you filed the joint return
- You are widowed or
- You have not been a member of the same household as the spouse with whom you filed the joint return at any time during the 12-month period ending on the date you request relief
If at the time you signed the joint return you had actual knowledge of the item that gave rise to the understatement of tax, you do not qualify for separation of liability relief.
If you do not qualify for innocent spouse relief or separation of liability relief, you may still qualify for equitable relief. To qualify for equitable relief, you must establish that under all the facts and circumstances, it would be unfair to hold you liable for the understatement or underpayment of tax.
If you request relief from joint and several liability, the IRS is required to notify the spouse with whom you filed the joint return of your request and allow him or her to provide information for consideration regarding your claim.
This leads us to the second topic of what happens if a tax lien attaches to a client’s real property or any other property held by a party, and what does that mean in regards to equitable distribution? The IRS can attach what is called a lien to any and all property a client owns. This includes real estate, bank accounts, personal injury awards, etc. This also means that the IRS has a right to garnish these assets if they are sold or if money is received by a party.
Under IRC section 6321 a tax lien attaches to all of a taxpayer’s property and rights to property. This includes property acquired after the lien is established.
Under 31 U.S.C. section 3713, a lawyer who distributes the proceeds of a settlement or judgment or the sale of a house for example, with knowledge or notice of the existence of a tax lien, may be personally liable for the amount of the tax.
In most cases, as it concerns real estate, the title company will find the lien when doing a judgment search and the real estate attorney will then have full knowledge of it. If the real estate attorney then releases the funds despite the lien, he may be personally liable for the same.
What does this mean in terms of your divorce? It puts parties’ at risk, because even through a final agreement may state that one party receives the proceeds from the sale of the house, a tax lien will take priority over the agreement, often leaving the party with nothing. Therefore you should be aware that even if you sell a home during your divorce or agree that you are to receive a home as part of your settlement, your attorney may not be able to release the funds to you if there is a tax lien issued against you and the IRS may garnish the proceeds from the sale of the property. This goes for personal injury settlements as well. Your attorney may not be able to release the funds to you if there is a tax lien issued against you.
While these are extreme cases it is important to be aware of the implications owed taxes may have on your divorce and the division of debts and assets.