Innocent Spouse Status versus the Federal Tax Lien

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The case of United States v. Kraus, No. 3:16-cv-5449 (W.D. Wash. April 3, 2018) demonstrates the problems that can occur when your spouse engages in tax protestor action even if you were “innocent.” The result here for the wife is the loss of her home, even though she has no personal liability for the unpaid tax. She argues that such a result renders her innocent spouse status somewhat meaningless; however, the court points out that innocent spouse status relieves the individual of personal liability but does not destroy the federal tax lien or the remedies available in connection with the lien.

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Ms. Lao married Mr. Kraus in 1988. At the time of the decision, they had three children ages 16, 24, and 27. During almost all of the marriage, Mr. Kraus earned the money used by the couple and she took care of the family. He handled all of the family finances, including tax filing, and gave her an allowance for household expenses. He stopped filing taxes in 1999, claiming that only federal employees need file tax returns. He ran a jewelry business with his brother. When the IRS audited the business and him individually, he did not engage in the audit, causing the agent to determine taxable income without the benefit of his assistance. As a result, the agent determined a huge liability because of the lack of expenses to offset the income. In addition to owing taxes for the years of non-filing, Mr. Kraus had numerous frivolous filing penalties for his tax protestor submissions to the IRS in response to its correspondence.

The couple sold their prior residence in 2003 and purchased a new home. At the time of the suit to foreclose, they had almost completely paid off the home. Mr. Kraus had also “transferred” the home to a trust though the couple and their children continued to live in the home, make all decisions related to the home, and pay all of the bills. Mr. Kraus told Ms. Lao that the transfer to the trust was for estate planning purposes and to protect the property from frivolous suits.

The couple was divorced in 2010 and she began working at a retail store. Mr. Kraus continued to live in the marital home and they split the bills. When the tax situation arose, she applied for and received innocent spouse status under IRC 66, since Washington is a community property state. Despite her innocent spouse status, the IRS sought to foreclose its lien on the property owned by the couple. The court quickly brushed aside the fraudulent transfer and determined that the lien attached to the property. Ms. Lao argued that allowing the IRS to foreclose on the house would render her IRC 66 relief “an empty shell of false security.” The court responded that IRC 66 relief does not entitle her to prevent foreclosure. “While innocent spouse relief prevents the assessment of a tax against Lao individually in any separate property she may possess, it does not affect the ability of the Government to pursue collection remedies against Lao’s interest in community property.” Under Washington law, “all debts of each spouse that are acquired during the marriage attach to the marital community as a whole and one spouse’s tax liabilities are presumed to be community debts if they are incurred during the marriage.”

Even if she obtained a separate property interest after the divorce, she took that interest subject to the preexisting liens or mortgages. “Any separate interest that Lao possesses in the subject property must lie in the equity that exceeds the preexisting mortgage and liens.”

The court finds an open question of whether the lien could continue to grow after her interest in the property separated from the marital community. The court said that interest accruing after the divorce may only attach to his separate property and requested additional briefing on this point. It appears that the IRS will obtain permission to foreclose on the entire property and sell it, leaving her with money from the sale but no home where she and the children, one of whom is a minor, have lived for 15 years. I was surprised that the court did not apply the equitable factors in United States v. Rogers, 461 U.S. 677 (1983) to decide whether selling the home under these circumstances was appropriate. Applying the factors in that case might cause the court to pause in making the decision to sell the property at this time – at least until the youngest child reaches the age of majority.

The case demonstrates the limits of innocent spouse status. Being an innocent spouse does not stop the IRS from taking collection action that can have a negative impact on the innocent spouse where property interests of the non-liable spouse remain intertwined with the liable spouse. While she will receive some equity from the sale of the home, this situation causes her to lose her home despite being innocent of the actions causing the liability.

For those interested in the power of the federal tax lien, the Pro Bono & Tax Clinics committee of the ABA Tax Section will host a panel discussing Kraus and other lien cases at the May Meeting in D.C. next week. Christine

 

Comments

  1. Norman Diamond says:

    ‘Under Washington law, “all debts of each spouse that are acquired during the marriage attach to the marital community as a whole and one spouse’s tax liabilities are presumed to be community debts if they are incurred during the marriage.”’

    That makes sense for tax liabilities because the income on which the tax arises became community income. But when a penalty relates to a person’s behaviour other than the amount of tax, does Washington law say that the punishment is also presumed to be a community punishment? There’s another Washington where another court in a famous healthcare ruling distinguished penalties from taxes.

    Back to debts, though off-topic for taxes: If one spouse murdered someone the other spouse doesn’t have to serve half the prison sentence, but if a wrongful death case puts a large civil liability on that spouse then is the liability presumed to be a community debt?

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