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July 25, 2008

Refunds After Innocent Spouse Relief Granted

Federal Income Tax

Houston Tax Attorney

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If a taxpayer pays the couple’s income taxes and is then granted innocent spouse relief for the liability, is the innocent spouse entitled to a refund of the amount paid?  The 9th Circuit Court of Appeals addressed this in Orlock v. Commissioner.

Facts & Procedural History

The IRS granted the wife innocent spouse relief. Prior to obtaining this relief, the wife had paid part of the joint tax liability. Part of the payment was made from the wife’s separate property and the rest was paid from the husband and wife’s community property.

The taxpayer petitioned the U.S. Tax Court to determine whether the IRS correctly handled her innocent spouse relief claim. The IRS agreed that the wife was entitled innocent spouse relief and a refund for the amount paid from her separate property, but it did not agree that she was entitled to a refund for the amount paid from her community property. The U.S. Tax Court agreed with the IRS.

Joint Liability for Taxes

Federal tax laws generally look to state property law to determine what rights parties have to property.   In community property states, such as Texas, most property acquired by spouses during the marriage is subject to the creditors of either spouse. In common law or separate property states, such as Colorado, property acquired by spouses during the marriage may only be subject to the creditors of one of the spouses.

Despite these state laws, Federal tax law provides that married taxpayers who file joint tax returns are both liable for the full amount of tax on the tax return. They are also jointly responsible for any understatement of tax on the return.

The IRS has the authority to rule that one of the spouses is not personally liable for this type of joint understatement of tax. This is often referred to as innocent spouse relief.

Submit Refund Claims to Recoup Payments

This brings us to the Orlock case.  If the taxpayer innocent spouse pays for the tax liability with both their separate and community property, are they entitled to a refund once innocent spouse relief is granted?  The U.S. Tax Court had concluded that the innocent spouse is only entitled to a refund for the payments made with their separate property.  But what about the community property payment?  The 9th Circuit concluded that the innocent spouse is only entitled to a refund for payments made from their separate property.

This presents a number of procedural questions, such as how the IRS is to evaluate refund claims submitted by innocent spouses after the relief is granted?  The IRS is generally not privy to information that would show what payments are and are not separate property.  The refund claim forms also do not request this information.

Setting these procedural issues aside, the Orlock case serves as a reminder that those granted innocent spouse relief need to submit refund claims to recoup any separate property payments they made.

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