March 2000

Spousal Liability for Federal and State Taxes

by Martin Silver

This article addresses questions dealing with the liability of spouses and ex-spouses for federal taxes and Washington state business taxes. To what extent is the community and separate property of each spouse liable for prenuptial tax debts of one spouse? To what extent is the community and separate property liable for tax obligations that accrue during marriage? What is the tax liability of separated and former spouses? Finally, to what extent may spouses, by contractually varying how they hold property and earnings, also vary which property and earnings become liable for unpaid taxes?

Federal Taxes

Under the rule announced by the United States Supreme Court in Poe v. Seaborn, 282 U.S. 101, 51 S. Ct. 58 (1930), each spouse in a community property state is individually liable for the tax on one-half of the community income, regardless of which spouse actually earns the income, and regardless of whether a joint or separate return is filed. If the parties file a joint return during marriage, their liability is joint and several as to the entire debt, and extends to the community property and the separate property of each. If they file as married filing separately, each must pick up one half of his/her own income and one half of the other’s. The potential for havoc is evident if the spouses separate in anticipation of a divorce, especially where one will not disclose income to the other.1

Spouses may by agreement convert separate property (including future acquisitions) into community property, and may also agree that their existing property and future acquisitions shall be separate property.2 The Internal Revenue Service has generally indicated that agreements affecting the status of property or income by couples in a community property state will be valid for federal income tax purposes.3 As will be discussed later, a question arises as to whether, and to what extent, altering the form by which property is held also alters the property subject to collection.

Washington state does not have an income tax. Where one or both spouses run a business, however, liability for unpaid taxes may fasten to the spouses. Liability will extend to the separate property of the spouse active in the business and to the community, even if only one spouse is active. Washington has not enacted legislation similar to the federal legislation which offers protection to an innocent spouse. Therefore, liability for unpaid state taxes is affixed on the basis of community property law, so that the community is generally liable for the whole debt.4 

Not uncommonly, a federal tax liability exists against one spouse at the time he or she marries. The enforceability of that debt against community property constitutes one of the few exceptions to the "marital bankruptcy" rule.5  The Ninth Circuit has ruled that community property may be levied and sold, and one-half of the proceeds applied to a spouse’s premarital federal tax debt.6 But for the Overman case, the most the federal government might have laid claim to would have been the liable spouse’s separate property, earnings and accumulations.

Suppose that the spouses-to-be have entered into a prenuptial agreement making their future earnings separate property. Can this insulate one-half of the non-liable spouse’s erstwhile community earnings from governmental levy, the Overman case notwithstanding? There is no Washington case law directly on point, but it would seem that such an agreement should be successful if, under Washington law, it would serve to establish the separate property status of the nonliable spouse’s earnings. This is so, because for federal tax collection purposes, state law determines what property rights a party has, while federal law determines what collection powers the federal government has as to that property.7 A recent district court ruling in Texas rejected an IRS assault on a prenuptial separate property/future earnings agreement, and found that since the wife’s earnings would be regarded as separate under Texas law, they were not subject to levy by the IRS.8 

It should be noted, however, that the government may challenge whether a separate property agreement covering earnings has been observed by the spouses.9 Thus, a federal revenue officer may look to whether one party used her earnings to pay the admittedly separate property expenses of a spouse, such as auto or student loan payments. The spouses are also well advised to deposit separate earnings into separate accounts, and to pay into a third account from which community living expenses are paid out in as nearly equal amounts as possible.

Suppose the separate property/separate earnings agreement is executed during marriage. The relevant question would appear to be whether the agreement was executed after the debt was incurred, not whether the agreement was entered into before or after marriage. RCW 26.16.120 provides that a marital agreement "shall not derogate from the rights of creditors." As the premarital tax liability of one of the spouses was not a community obligation to begin with, execution of the agreement even after marriage does not deprive a community creditor of community property against which it might have levied but for the agreement.10 If a post-marital agreement making a spouse’s earnings separate property would be effective under Washington law, the IRS should be bound by it also.11 

Suppose a spouse has a Washington state tax liability (or warrant) at the time of entering the marriage. Can collection be made against the taxpayer spouse’s one-half interest in all community property? The answer should be no because of RCW 26.16.200.12 Even assuming the tax debt is reduced to a filed warrant (i.e., judgment status), RCW 26.16.200 would appear to limit the Department of Revenue to a claim against the liable spouse’s separate property and his or her post-marital "earnings and accumulations." The Overman case exception created with regard to federal tax liens relied on the supremacy of federal law over Washington law regulating the rights of creditors generally, a consideration which should not apply to Washington state taxes.

Federal Taxes

As discussed earlier, taxpayers who sign a joint return are jointly and severally liable on the resulting liability. Frequently, one taxpayer works for a family business which may itself be either community or separate property. Even if the business is operated in the corporate or LLC form, failure on the entity’s part to make federal tax deposits may result in imposition against the working spouse of an IRC Section 6672 assessment (100 percent penalty) in the amount of the FICA, Medicare and income tax withheld but not remitted to the government. While the resulting personal tax liability and lien typically run only in the name of the spouse deemed responsible for the failure to deposit, the obligation would appear to be against the community, even if the business entity itself is separate property. This is because of the presumption that debts incurred during marriage are community obligations, and because the community had the economic benefit from the earnings of the spouse working for the business.13  The noninvolved spouse’s separate property should not be accessible. Moreover, under the reasoning of the Calmes case, it may also be possible to insulate the noninvolved spouse’s earnings by a separate earnings clause in a separate property agreement. If the 100 percent penalty accrues during marriage but before the agreement is executed, the IRS may argue that the agreement was voidable under state law as being in derogation of the rights of creditors.14 

Washington Taxes

The Washington State Department of Revenue takes a different position as to the effectiveness of a prenuptial separate property agreement. In Determination 97-168, 17 WTD 142 (1998), the husband and wife entered into a prenuptial separate property agreement. The agreement did not discuss future earnings. The husband’s family corporation, for which he continued to work during the marriage, was scheduled as separate property. The corporation failed to remit retail sales tax during a period of the marriage, and the husband was found personally liable as a responsible officer for the defunct corporation’s taxes. The taxpayers appealed the assessment and argued, inter alia, that because of the prenuptial agreement, the Department could not collect any portion of the debt from the separate assets or earnings of the wife. In a broadly worded decision, the Department of Revenue ruled that the agreement was not binding on the Department, as it had no effect on creditors under RCW 26.16.120. Analyzing the matter under "traditional community property law," the Department of Revenue found the community, and therefore the wife’s community property earnings (but not her separate property), liable under the economic benefit doctrine and under RCW 26.16.030.

While the ruling may be correct because the prenuptial agreement appears not to have specifically referenced "future earnings" as remaining separate, the reasoning of the Department of Revenue is incorrect in concluding that the prenuptial agreement did not apply to the Department. The Department was not a creditor of the unmarried parties at the time the antenuptial agreement was signed and so the agreement was effective against subsequent creditors.15 Had the agreement made earnings separate, as did the agreement in Calmes, there would seem no ground for disregarding it. The Department appears also to have erred, although in the taxpayer’s favor, in holding that after divorce the wife’s earnings (no longer community property) would not be liable for the tax debt. The tax debt, having been characterized as a community debt, would seem to follow former community property even after it became separate property in the hands of a divorced spouse.16 

Federal Taxes

Under Poe v. Seaborn, each spouse has an obligation to report for federal income tax purposes half of her own income and half of her spouse’s. Parties who have separated and may be in the process of divorce often become concerned that they cannot get information on income earned by their spouses, and may also complain that they would like to file joint returns but cannot get their spouse’s cooperation. As to the second concern, there is no right to file a joint return if one spouse is unwilling, but nothing prevents the other spouse from filing as married filing separately. As to the first question, there are several ways to approach the problem posed by Poe v. Seaborn.

First, if the parties are living separate and apart, post-separation earnings are separate income.17 But where the spouses have commenced to live apart in the middle of the year, pro-rating the earnings between community and separate would appear to be necessary even if a spouse receives no benefit from the other spouse’s earnings. Moreover, since community property does not lose its character merely by separation, each spouse presumably remains liable for the tax on (and deductions with respect to) one-half of nonearned community income. The responsibility for reporting one-half of the community income prior to divorce would continue until the community property is actually divided by agreement.18 

Relief under IRC Section 66

A second approach to overriding the rule in Poe v. Seaborn is through use of IRC Section 66. Unfortunately, the section is both complex and unnecessarily restrictive. Section 66(a) provides that if spouses file separately, live apart at all times during the year, and do not transfer earned income from one to the other, the non-earning spouse will be responsible only for his or her own earned income.19

Sections 66(b) and (c) appear to provide relief from taxation for any community income, not just earned income, even if the parties live together for a portion of the year, although here, too, the requirements for relief are stringent. Section 66(b) is not a relief provision. In other words, it cannot be used by one spouse to avoid liability for tax on community income earned or received by the other spouse. It "allows" (but does not require) the IRS to disregard the "benefits" of income-splitting to a spouse if that spouse treated any income as his or her own and "failed to notify" the nonearning spouse of the nature and amount of the community income before the due date of the return. Therefore, the spouse receiving the community income can avoid application of Section 66(b) by giving the other spouse the required notice, even if that spouse does not benefit from the income.

Section 66(c) relieves a spouse of liability for community income if certain conditions are met. The section affords relief to a separately filing spouse only if she "did not know of, and had no reason to know of" the other’s income and if it would be inequitable to tax community income to her. Section 66(c) extends not only to earned income but also to trade, business and partnership income, as well as to income derived from separate property. Section 66(c) generally leaves the spouse receiving the income in the driver’s seat as to whether to notify the other spouse of the community income, regardless of who controlled it or whether the noncontrolling spouse even had enough of the income to pay the taxes. Court decisions construing whether a spouse knows, or has reason to know, of the other’s income further limit the utility of Section 66(c). For example, in one case where a husband earned real estate commissions, deposited them secretly into an account with his mother, and then withdrew funds from the account and deposited them into a joint account with his wife to be used for living expenses, the wife did not qualify for Section 66(c) relief because, while she was not aware of the arrangements her husband had with his mother, she was aware that he earned commissions.20 Other cases have held that the mere knowledge of the income-producing activity, but not necessarily the exact amount or specific items of income, is enough to disqualify a spouse for Section 66(c) relief.21 The courts also look for evidence of whether the spouse benefited from the income, although there is some disagreement as to what constitutes "benefit."22 

The 1998 Reform and Restructuring Act added an additional equitable relief provision to Section 66(c), providing that:

[I]f taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or deficiency (or any portion of either) attributable to any item for which relief is not available under the preceding sentence, [i.e., Section 66(c) requirements] the Secretary may relieve such individual of such liability.

This language is identical to that found in Section 6015(f), the section dealing with relief from joint return liability for an innocent spouse, also added by the 1998 Act. On December 21, 1998, the IRS issued Notice 98-61 to provide interim guidance.23 Presumably, the IRS will apply the notice to the new equitable relief provisions under Section 66(c). The notice sets certain threshold requirements for equitable relief and lists circumstances under which relief will ordinarily be granted. Pro and con factors to be considered in determining where relief will be granted in other cases are also listed.

Relief will ordinarily be granted when, in addition to other criteria which normally will be met, the requesting spouse had no reason to know that the tax would not be paid, would suffer undue hardship if relief were not granted, and the tax liability for which relief is sought is attributable to the nonrequesting spouse. If relief is not ordinarily available, the IRS will look to additional factors as favoring relief, such as whether the requesting spouse was abused by the other spouse, or whether the divorce instrument obligated the nonrequesting spouse to pay the liability. Factors weighing against relief include whether the tax liability is attributable to the requesting spouse, and whether the requesting spouse received a significant benefit (beyond normal support) from the unpaid liability or items giving rise to the deficiency.

Relief from the joint and several liability resulting from the filing of a joint return may be available under IRC Section 6015.24 Section 6015(a) generally addresses the case where one spouse, unbeknownst to the other, has either excluded income from the return or misreported in some other respect. While there is nothing to prevent application of the innocent spouse provisions to married couples, for obvious reasons it is usually in a case where spouses have separated or divorced that one spouse wants to be relieved of his or her share of the joint tax liability. Qualifying for innocent spouse relief is technical, but suffice it to say that the 1998 act liberalized the rules and eased qualification, including apportioned relief if the innocent spouse knew of the fact of, but not the extent of, the understatement. Basically, a spouse may be relieved of liability on a joint return upon establishing that he or she did not know and had no reason to know that there was an understatement on the return. The spouse may elect innocent spouse relief within two years from the date the IRS begins collection against the electing spouse, such as wage garnishment or other levy. In addition, IRC Section 6015(f) as added in 1998 contains a catchall provision allowing the IRS to provide equitable relief in cases where innocent spouse relief may be unavailable. Notice 98-61, already discussed in connection with the same relief provision under Section 66(c), delineates the factors the IRS will consider in determining entitlement to equitable relief.

Section 6015(c) provides for divorced or separated persons to elect "separate liability" with respect to a joint return. Such an election limits exposure to the amount of tax which would have resulted from the filing of a separate return. The election for separate liability should ordinarily be easier than seeking innocent spouse relief because it is available, unless the IRS shows the taxpayer had actual knowledge of the item giving rise to the deficiency (as opposed to the "known or should have known" standard for innocent spouse relief). The procedure for electing separate liability is the same as that for electing innocent spouse relief.

In keeping with the philosophy of the 1998 legislation overall, a joint filer may seek review by the Tax Court of IRS denial of innocent spouse or separate liability relief.

State Taxes

A liability with the Department of Revenue incurred by one spouse during separation, but before divorce, presents different concerns because of the absence of statutes such as IRC Sections 66 and 6015. Should the business be a sole proprietorship run by one spouse, or should personal liability for retail sales tax be assessed against the spouse active in a corporate business, the state would presumably regard its assessment as running against the marital community. The nonactive spouse would presumably argue that under RCW 26.16.140 the liability for taxes should follow the spouse earning income from the business. The nonactive spouse could also argue that the community had terminated, so that any business tax liability incurred by the spouse active in the business became a separate tax liability of the active spouse only.25 

Under Determination 97-168, discussed above, a community liability attributable to the business activity of one spouse might not reach the earnings of the nonactive spouse after a divorce. By extension of that reasoning, an assessment against the active spouse might not reach the former community property awarded to the nonactive spouse in a divorce.

One frequent complaint of formerly married persons is that one spouse, generally the more visible and responsible, becomes the target of collection with respect to a large federal income tax liability on which both ex-spouses are jointly liable. If the target spouse cannot establish "innocent spouse" status or elect separate liability status, it may nevertheless help his or her position to get information as to what efforts the IRS is making to collect from the other spouse, and how much if any has already been collected. The ability to obtain this information, previously unavailable because of privacy rules, was added in the 1996 Taxpayer Bill of Rights. Section 6103(e)(8) allows for disclosure of collection activities on a joint income tax return. This applies to divorced taxpayers and those who are no longer living in the same household. The information which may be disclosed includes the nature of the collection activity undertaken against the other spouse and the amount collected in toto.

There is no similar opportunity with respect to a Washington state tax debt because of nondisclosure rules. Legislation similar to IRC Section 6103 will probably be required to allow the target spouse to share in information as to collection being undertaken with regard to his or her former spouse.

1 This problem is ameliorated for federal income taxes by RCW 26.16.140 and IRC Section 66, both discussed later in this article.

2 RCW 26.26.120, 26.16.050. Cross, Community Property, (rev. 1985, 61 Wash. L. Rev. 13, 101 (1986). This includes the power to contractually make future earnings separate. See discussion and cases cited in Cross, p. 105.

3 Rev. Pub. 555 (1998). Rev. Rul. 77-359, 1977-2 C.B. 24

4 Moreover, the basic presumption that a debt incurred by either spouse is a community debt, and thus enforceable against the community property, is not easily overcome. Cross, Community Property, at 116.

5 The 1969 and 1983 amendments to RCW 26.16.200 permit enforcement against the earnings and accumulations of either spouse for that spouse’s premarital debts if reduced to judgment within three years of marriage. The separate property of the obligated spouse is, of course, reachable by the taxing authorities.

6 United States v. Overman, 424 F.2d 1142 (9th Cir. 1970). The court based its holding on two grounds: the reasoning that a spouse has a sufficient "right to property" under Washington community property law to be leviable under IRC Section 6321, and federal supremacy as to the right of the United States as a creditor of the taxpayer.

7 United States v. Rodgers, 461 U.S. 677 (1983)/ The reasoning of the court in Overman was, in fact, that the taxpayer had a sufficient property interest under Washington law to be lienable, while federal law determined the powers of the federal government to execute on the liened property.

8 Calmes v. United States, 926 F. Supp. 582 (N.D. Tex 1996). The court said that since federal law followed state law as to property rights (the same having also been the reasoning in the Overman case), and since Texas law would respect such an agreement, the federal government was bound by the agreement. The court also said that such an agreement was not a fraudulent conveyance, noting that among other things, the parties exchanged equally valuable consideration in renouncing an interest in each other’s future earnings.

9 It may be difficult to say whether parties have observed an agreement. Clearly, commingling of earnings will do the separate status argument no good. Consider also the case of Kolmorgan v. Schaller, 51 Wn. 2d 94 (1957), where the court concluded that despite a separate property agreement, a wife’s earnings had not lost their community character because the wife had used her earnings to pay ordinary family expenses. This case is criticized in Cross, Community Property, p. 105. In a questionnaire the IRS circulates to taxpayers making an offer in compromise, the Government requests "copies of any and all pre/ante [sic] or separate property agreement(s), with affidavits from each of the parties, under penalty of perjury, regarding adherence to said agreement(s)."

10 The matter is put this way by Cross: "The separate property agreement will not be given effect to insulate what otherwise would be community property from the community creditor whose basic claim existed at the time of the agreement. It will be effective against the subsequent creditor whether he knows of the agreement or not." (citations omitted), at 107. In fact, the case cited by Cross in support of the first sentence is one in which the separate property agreement was one entered into during the marriage. Marsh v. Fisher, 69 Wash. 570 (1912).

11 See footnotes 3 and 6, supra. Should the IRS not agree with the taxpayer’s position, the taxpayer may appeal the proposed collection action to the IRS Appeals Division. If a satisfactory result is not obtained, the taxpayer may seek review of the proposed collection activity in U.S. District Court and, in most cases, the U.S. Tax Court. The statutory codification of the appellate review and the broadening of review rights to include court review occurred under the 1998 legislation.

12 Subject to the well-known exemptions and the "earnings and accumulations" rule, RCW 21.16.200 provides that, "Neither husband or wife is liable for the debts or liabilities of each other incurred before marriage..."

13 Cross, Community Property, 116.

14 RCW 26.16.120.

15 The Determination relied without analysis on the proviso in RCW 26.16.120 that the agreement not be in "derogation" of creditors. The Determination failed to consider that the Department was at the time the agreement was entered into neither a creditor of the marital community, nor of the wife in her separate capacity. It has been observed that the language of RCW 26.16.120 just cited in its "naive simplicity...does not define what rights the creditors have, nor does it provide any procedure for the creditor to enforce those rights." Brachtenbach, Community Property Agreements — Many Questions, Few Answers, 37 Wash. L. Rev. 469, 471 (1962).

16 Bureau of National Affairs Portfolio No. 638, A-22; Kalinkas, Taxation of Community Income: It is Time for Congress to Override Poe v. Seaborn, 58 La. Law Rev. 73, 74 (1997); Cross, Community Property, supra, 144.

17 RCW 26.16.140; Rev. Rul 68-66, 168-1 CB 33

18 Gilbert B. Hay, 13 T.C. 840 (1949); Phillip S. Coffer, 11 T.C.M. 346 (1952), discussed in Community Property Deskbook, section 7.20.

19 Section 66(a), like RCW 26.16.14, applies only to earned income, but is more restrictive than the RCW in that the spouses must live apart at all times during the year.

20 Bozek v. Comr., T.C. Memo 1986-37

21 McGee v. Comr., 93-1 USTC ¶50,015 (5th Cir. 1992), aff’g T.C. Memo 1991-510; Costa v. Comr., T.C. Memo 1990-572

22 Compare Trout v. Comr., T.C. Memo 1992-696, granting relief where spouse did not benefit from the income beyond normal support, with Bozek v. Comr., supra note 20, where payment of common household benefits disqualified the spouse seeking relief.

23 Notice 98-61, 1998 I.R.B. 13.

24 The innocent spouse and separate liability election rules, discussed hereinafter, provide that community property laws are disregarded so that the rule of Poe v. Seaborn does not override the intended effect of the innocent and separate liability relief.

25 See the discussion in Cross, Community Property at 124.

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