Expert Advice

By Chris P. Rettig
     
      Tax Law
      The IRS Is Watching Your Clients' Divorce
      In a newly dogged approach to narrowing the tax gap?the approximately $300 billion in taxes not collected due to underreporting, nonfiling, and nonpayment?agents from the IRS and the California Franchise Tax Board have been instructed to review court records for relevant financial information. During an audit, an agent who encounters changes in a taxpayer's filing status, payment or receipt of alimony or other support, or unusual legal fees will likely plumb court records for more information.
      Attorneys advising divorcing clients need to be acutely aware of how information in court records may inadvertently result in tax problems and liabilities.
      Leave the back door open. Whether an otherwise innocent spouse is entitled to relief from tax liabilities related to unreported income depends on his or her actual and presumed knowledge of it. A declaration setting forth a lavish lifestyle by the client spouse that is not otherwise supported by information on the tax returns could be sufficient to deny relief in a subsequent tax proceeding. Although the declaration may be important in determining an award of spousal or child support, it may be more beneficial to have that information generated by a forensic accountant or through the other spouse's testimony rather than directly through the client.
      When unreported income or hidden assets are discovered, clients often are eager to have counsel rush into court to seek a support order, without considering the various tax-related implications associated with disclosing the information. But disclosures during the dissolution proceeding will become a benchmark in future tax proceedings. It may be wise to contact experienced tax counsel to evaluate the potential tax implications of publicly disclosing the information.
      Counsel may also engage a separate forensic accountant to preserve the privilege of the information in any subsequent tax proceeding. This can also be helpful when advising separated clients about what filing status to choose. If separate returns are filed during marital separation, the spouses may subsequently decide to file joint returns without first satisfying their entire joint tax liability. If joint returns are filed, separate returns may not be filed later?and the spouses would be held jointly and severally liable for potentially significant deficiencies for taxes, interest, and penalties.
      Is voluntary disclosure possible? In certain situations, counsel might recommend amending several previously filed state and federal individual and business returns to appropriately report income and assets.
      If income has intentionally not been reported or if returns have not been filed, the tax and civil penalties may be assessed at any time; the normal three-year statute of limitations does not apply if civil tax fraud is discovered. However, the IRS has the burden of proving tax fraud. The statute of limitations for criminal prosecution, which is usually six years, runs from the time the offense was committed: usually the due date of the tax return. One offense may result in both civil and criminal tax penalties.
      The IRS has generally maintained an informal policy of not recommending a criminal tax prosecution if a taxpayer voluntarily reports previously undisclosed information before a "triggering event" such as a marital dissolution, a business breakup, or a termination of a disgruntled employee. Currently, the triggering event tends to be limited to an initial contact by the government. Although a taxpayer may not generally rely on this to remain out of trouble, it is often helpful to know the government's view of such voluntary disclosure.
      Feeling lucky? If returns are not amended to include previously unreported income, both spouses must be advised of the potential civil and criminal tax exposure. For various reasons, it may be in their best economic interests for the tax returns to not be amended and the tax-related liabilities to not be paid. Spousal support would then generally be based on both reported and unreported income. However, the earning spouse might be forced to continue a pattern of failing to appropriately report income to satisfy the support obligations.
      If the returns are not amended, the earning spouse is rolling the dice in the hope that the government will not discover the omission. If discovered, the earning spouse would generally not be able to recapture support already paid because, presumably, such amounts will have been exhausted for housing, food, and other expenses. To satisfy delinquent tax liabilities and penalties, the government might then seize the wages, bank accounts, and even the support payments. If allowed to accrue, the tax liabilities might result in the financial insolvency of the earning spouse, effectively killing the goose that laid the golden egg.
     
      Charles P. Rettig (rettig@taxlitigator.com), a member in the Los Angeles office of Hochman, Salkin, Rettig, Toscher & Perez, concentrates on tax and estate planning.
     

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