6. Tax Court jurisdiction to review an adverse IRS determination of a bond issue's tax-exempt status (sec. 3106 of the bill and sec. 7478 of the Code)

Present Law

Interest on debt incurred by States or local governments generally is excluded from gross income if the proceeds of the borrowing are used to carry out governmental functions of those entities and the debt is repaid with governmental funds (sec. 103). Interest on debt incurred by those governments where the proceeds are used to finance activities of other persons and the repayment of which is derived from the funds of such other person (e.g., private activity bonds), is taxable unless a specific exception is included in the Code.

In general, an initial determination of whether interest on State or local government bonds is tax-exempt is made by issuers when the bonds are issued. This initial determination is made by reference to how the bond proceeds are "to be used" (sec. 141). Intentional acts after the date of issuance to use bond-financed property (indirectly, a use of bond proceeds) in a manner not qualifying for tax exemption may render interest on the bonds taxable, retroactive to the date of issuance. Like other tax positions taken by taxpayers, this initial determination, and issuer decisions relating to the effect of subsequent actions are subject to review and challenge by the IRS under regular examination procedures.

A State or local government that seeks to issue bonds, the interest on which is intended to be excludable from gross income under section 103, can request a ruling from the IRS regarding the eligibility of such bonds for tax-exemption. The prospective issuer can challenge the IRS's determination (or failure to make a timely determination) in a declaratory judgment proceed the in the Tax Court under Code section 7478. Because bondholders, not issuers, are the parties whose tax liability is affected, issuers are not allowed to litigate the tax-exempt status of the bonds directly after the bonds are issued.

Reasons for Change

The Committee believes that issuers of governmental bonds, as parties with a strong incentive to ensure the continued tax-exemption of outstanding bonds, should have the opportunity to challenge IRS revocations of the tax-exempt status of the bonds, to protect the holders of those bonds and the market better.

Explanation of Provision

The provision extends the declaratory judgment procedures currently applicable to prospective bond issuers to issuers of outstanding bonds. The issuer must provide adequate notice to outstanding bondholders, and the bondholders are authorized to intervene in court proceedings brought under this provision. The statute of limitations on assessment and collection of the tax liability of the bondholders is suspended during the pendency of the proceeding.

Effective Date

The provision applies to determinations of tax-exempt status made after the date of enactment. A special rule provides that, in the case of a determination under a technical advice memorandum the public release of which occurs within one year of the date of enactment, a pleading may be filed not later than 90 days after the date of enactment.

7. Civil action for release of erroneous lien (sec. 3107 of the bill and sec. 6325 of the Code)

Present Law

Prior to 1995, the provisions governing jurisdiction over refund suits had generally been interpreted to apply only if an action was brought by the taxpayer against whom tax was assessed. Remedies for third parties from whom tax was collected (rather than assessed) were found in other provisions of the Internal Revenue Code. The Supreme Court held in Williams v. United States, 115 S.Ct. 1611 (1995), however, that a third party who paid another person's tax under protest to remove a lien on the third party's property could bring a refund suit, because she had no other adequate administrative or judicial remedy. In Williams, the IRS had filed a nominee lien against property that was owned by the taxpayer's former spouse and that was under a contract for sale. In order to complete the sale, the former spouse paid the amount of the lien under protest, and then sued in district court to recover the amount paid. The Supreme Court held that parties who are forced to pay another's tax under duress could bring a refund suit, because no other judicial remedy was adequate.

Reasons for Change

The Committee believes that third parties should have a mechanism to release an erroneous tax lien. Accordingly, the Committee believes it is appropriate to provide relief similar to that provided to third parties who are subject to wrongful levy of property.

Explanation of Provision

The provision creates an administrative procedure similar to the wrongful levy remedy for third parties in section 7426. Under this procedure, a record owner of property against which a Federal tax lien had been filed could obtain a certificate of discharge of property from the lien as a matter of right. The third party would be required to apply to the Secretary of the Treasury for such a certificate and either to deposit cash or to furnish a bond sufficient to protect the lien interest of the United States. Although the Secretary would determine the amount of the bond necessary to protect the Government's lien interest, the Secretary would have no discretion to refuse to issue a certificate of discharge if this procedure was followed, thus curing the defect in this remedy that the Supreme Court found in Williams. A certificate of discharge of property from a lien issued pursuant to the procedure would enable the record owner to sell the property free and clear of the Federal tax lien in all circumstances. The provision also authorizes the refund of all or part of the amount deposited, plus interest at the same rate that would be made on an overpayment of tax by the taxpayer, or the release of all or part of the bond, if the tax liability is satisfied or the Secretary determines that the United States does not have a lien interest or has a lesser lien interest than the amount initially determined.

The provision also establishes a judicial cause of action for third parties challenging a lien that is similar to the wrongful levy remedy in section 7426. The period within which such an action must be commenced would be 120 days after the date the certificate of discharge is issued to ensure an early resolution of the parties' interests. Upon conclusion of the litigation, the IRS would be authorized to apply the deposit or bond to the assessed liability and to refund to the third party any amount in excess of the liability, plus interest, or to release the bond. Actions to quiet title under 28 U.S.C. §2410 would still be available to persons who did not seek the expedited review permitted under the new statutory procedure.

Effective Date

The provision is effective on the date of enactment.

C. Relief for Innocent Spouses and for Taxpayers Unable to Manage
Their Financial Affairs Due to Disabilities

1. Spousal election to limit joint and several liability on joint return (sec. 3201 of the bill and new sec. 6015 of the Code)

Present Law

Relief from liability for tax, interest and penalties is available for "innocent spouses" in certain circumstances. To qualify for such relief, the innocent spouse must establish: (1) that a joint return was made; (2) that an understatement of tax, which exceeds the greater of $500 or a specified percentage of the innocent spouse's adjusted gross income for the preadjustment (most recent) year, is attributable to a grossly erroneous item of the other spouse; (3) that in signing the return, the innocent spouse did not know, and had no reason to know, that there was an understatement of tax; and (4) that taking into account all the facts and circumstances, it is inequitable to hold the innocent spouse liable for the deficiency in tax. The specified percentage of adjusted gross income is 10 percent if adjusted gross income is $20,000 or less. Otherwise, the specified percentage is 25 percent.

The proper forum for contesting the Secretary's denial of innocent spouse relief is determined by whether an underpayment is asserted or the taxpayer is seeking a refund of overpaid taxes. Accordingly, the Tax Court may not have jurisdiction to review all denials of innocent spouse relief.

Reasons for Change

The Committee is concerned that the innocent spouse provisions of present law are inadequate. The Committee believes that a system based on separate liabilities will provide better protection for innocent spouses than the current system. The Committee generally believes that an electing spouse's liability should be satisfied by the payment of the tax attributable to that spouse's income and that an election to limit a spouse's liability to that amount is appropriate.

The Committee intends that this election be available to limit the liability of spouses for tax attributable to items of which they had no knowledge. The Committee is concerned that taxpayers not be allowed to abuse these rules by knowingly signing false returns, or by transferring assets for the purpose of avoiding the payment of tax by the use of this election. The Committee believes that rules restricting the ability of taxpayers to limit their liability in such situations are appropriate.

The Committee believes that taxpayers need to be informed of their right to make this election and that the IRS is the best source of that information. The Committee also believes that the IRS should take appropriate steps to insure that both spouses are made aware of their tax situation, and not rely on a single notice sent to a single address to inform both spouses.

Explanation of Provision

In general

The bill modifies the innocent spouse provisions to permit a spouse to elect to limit his or her liability for unpaid taxes on a joint return to the spouse's separate liability amount. In the case of a deficiency arising from a joint return, a spouse would be liable only to the extent items giving rise to the deficiency are allocable to the spouse. Special rules apply to prevent the inappropriate use of the election.

Items are generally allocated between spouses in the same manner as they would have been allocated had the spouses filed separate returns. The Secretary may prescribe other methods of allocation by regulation. The allocation of items is to be accomplished without regard to community property laws.

The election applies to all unpaid taxes under subtitle A of the Internal Revenue Code, including the income tax and the self-employment tax. The election may be made at any time not later than 2 years after collection activities begin with respect to the electing spouse. The Committee intends that 2 year period not begin until collection activities have been undertaken against the electing spouse that have the effect of giving the spouse notice of the IRS' intention to collect the joint liability from such spouse. For example, garnishment of wages, a notice of intent to levy against the property of the electing spouse would constitute collection activity against the electing spouse. The mailing of a notice of deficiency and demand for payment to the last known address of the electing spouse, addressed to both spouses, would not.

The Tax Court has jurisdiction of disputes arising from the separate liability election. For example, a spouse who makes the separate liability election may petition the Tax Court to determine the limits on liability applicable under this provision. The Tax Court is authorized to establish rules that would allow the Secretary of the Treasury and the electing spouse to require, with adequate notice, the other spouse to become a party to any proceeding before the Tax Court. The Secretary of the Treasury is required to develop a separate form with instructions for taxpayers to use in electing to limit liability.

Allocations of items

Under the bill, allocation of items of income and deduction follows the present-law rules determining which spouse is responsible for reporting an item when the spouses use the married, filing separate filing status. The Secretary of the Treasury is granted authority to prescribe regulations providing simplified methods of allocating items.

In general, apportionment of items of income are expected to follow the source of the income. Wage income is allocated to the spouse performing the job and receiving the Form W-2. Business and investment income (including any capital gains) is allocated in the same proportion as the ownership of the business or investment that produces the income. Where ownership of the business or investment is held by both spouses as joint tenants, it is expected that any income is allocated equally to each spouse, in the absence of clear and convincing evidence supporting a different allocation.

The allocation of business deductions is expected to follow the ownership of the business. Personal deduction items are expected to be allocated equally between spouses, unless the evidence shows that a different allocation is appropriate. For example, a charitable contribution normally wold be allocated equally to both spouses. However, if the wife provides evidence that the deduction relates to the contribution of an asset that was the sole property of the husband, any deficiency assessed because it is later determined that the value of the property was overstated would be allocated to the husband.

Items of loss or deduction are allocated to a spouse only to the extent that income attributable to the spouse was offset by the deduction or loss. Any remainder is allocated to the other spouse.

Income tax withholding is allocated to the spouse from whose paycheck the tax was withheld. Estimated tax payments are generally expected to be allocated to the spouse who made the payments. If the payments were made jointly, the payments are expected to be allocated equally to each spouse, in the absence of evidence supporting a different allocation.

The allocation of items is to be made without regard to the community property laws of any jurisdiction.

If the electing spouse establishes that he or she did not know, and had no reason to know, of an item and, considering all the facts and circumstances, it is inequitable to hold the electing spouse responsible for any unpaid tax or deficiency attributable to such item, the item may be equitably reallocated to the other spouse. In cases where the IRS proves fraud, the IRS may distribute, apportion, or allocate any item between spouses.

Tax deficiencies

If a spouse makes the separate liability election, the liability for deficiencies determined after a joint return is filed is allocated to the spouse whose item gives rise to the deficiency. For example, if a deficiency is assessed after an IRS audit that relates to the husband's income that he failed to report on the return, the entire deficiency is allocated to the husband. If the wife elects separate liability, she owes none of the deficiency. The deficiency is the sole responsibility of the husband who failed to report the income.

If the deficiency relates to the items of both spouses, the separate liability for the deficiency is allocated between the spouses in the same proportion as the net items taken into account in determining the deficiency. If the deficiency arises as a result of the denial of an item of deduction or credit, the amount of the deficiency allocated to the spouse to whom the item of deduction or credit is allocated is limited to the amount of income or tax allocated to such spouse that was offset by the deduction or credit. The remainder of the liability is allocated to the other spouse to reflect the fact that income or tax allocated to that spouse was originally offset by a portion of the disallowed deduction or credit.

For example, a married couple files a joint return with wage income of $100,000 allocable to the wife and $30,000 of self employment income allocable to the husband. On examination, a $20,000 deduction allocated to the husband is disallowed, resulting in a deficiency of $5,600. Under the provision, the liability is allocated in proportion to the items giving rise to the deficiency. Since the only item giving rise to the deficiency is allocable to the husband, and because he reported sufficient income to offset the item of deduction, the entire deficiency is allocated to the husband and the wife has no liability with regard to the deficiency, regardless of the ability of the IRS to collect the deficiency from the husband.

If the joint return had shown only $15,000 (instead of $30,000) of self employment income for the husband, the income offset limitation rule discussed above would apply. In this case, the disallowed $20,000 deduction entirely offsets the $15,000 of income of the husband, and $5,000 remains. This remaining $5,000 of the disallowed deduction offsets income of the wife. The liability for the deficiency is therefore divided in proportion to the amount of income offset for each spouse. In this example, the husband is liable for 3/4 of the deficiency ($4,200), and the wife is liable for the remaining 1/4 ($1,400).

The rule that the election will not apply to the extent any deficiency is attributable to an item the electing spouse had actual knowledge of is expected to be applied by treating the item as fully allocable to both spouses. For example a married couple files a joint return with wage income of $150,000 allocable to the wife and $30,000 of self employment income allocable to the husband. On examination, an additional $20,000 of the husband's self employment income is discovered, resulting in a deficiency of $9,000. The IRS proves that the wife had actual knowledge that $5,000 of this additional self employment income, but had no knowledge of the remaining $15,000. In this case, the husband would be liable for the full amount of the deficiency, since the item giving rise to the deficiency is fully allocable to him. In addition, the wife would be liable for the amount that would have been calculated as the deficiency based on the $5,000 of unreported income of which she had actual knowledge. The IRS would be allowed to collect that amount from either spouse, while the remainder of the deficiency could be collected from only the husband.

Tax shown on a return, but not paid

The separate liability election also applies in situations where the tax shown on a joint return is not paid with the return. In this case, the amount determined under the separate liability election equals the amount that would have been reported by the electing spouse on a separate return. However, if any item of credit or deduction would be disallowed solely because a separate return is filed, the item of credit or deduction will be computed without regard to such prohibition. Similarly, a base amount and an adjusted base amount will be allowed in the determination of the taxable portion of social security and tier 1 railroad retirement benefits without regard to the rule in section 86(c). The calculation of the tax that would be shown on the separate return does not constitute the filing of a separate return. Other actions whose character may have been dependent upon the joint filing status of the taxpayer (for example, the making of a deductible IRA contribution under section 219) are unaffected by the election.

The separate liability election may not be used to create a refund, or to direct a refund to a particular spouse.

Special rules

Special rules apply to prevent the inappropriate use of the election.

First, if the IRS demonstrates that assets were transferred between the spouses in a fraudulent scheme joined in by both spouses, neither spouse is eligible to make the election under the provision (and consequently joint and several liability applies to both spouses).

Second, if the IRS proves that the electing spouse had actual knowledge that an item on a return is incorrect, the election will not apply to the extent any deficiency is attributable to such item. Such actual knowledge must be established by the evidence and shall not be inferred based on indications that the electing spouse had a reason to know.

Third, the limitation on the liability of an electing spouse is increased by the value of any disqualified assets received from the other spouse. Disqualified assets include any property or right to property that was transferred to an electing spouse if the principle purpose of the transfer is the avoidance of tax (including the avoidance of payment of tax). A rebuttable presumption exists that a transfer is made for tax avoidance purposes if the transfer was made less than one year before the earlier of the payment due date or the date of the notice of proposed deficiency. The rebuttable presumption does not apply to transfers pursuant to a decree of divorce or separate maintenance. The presumption may be rebutted by a showing that the principal purpose of the transfer was not the avoidance of tax or the payment of tax.

Notification of taxpayers

The Internal Revenue Service is required to notify all taxpayers who have filed joint returns of their rights to elect to limit their joint and several liability under this provision. It is expected that notice will appear in appropriate IRS publications, including IRS Publication 1, and in collection related notices sent to taxpayers.

The Internal Revenue Service should, whenever practicable, send appropriate notifications separately to each spouses. For example, where notifications are being sent by registered mail, it is expected a separate notice will be sent by registered mail to each spouse. This is intended to increase the likelihood that separated or divorced spouses will each receive such notices, as well as increase the likelihood that the Internal Revenue Service will be made aware of address changes that apply to one, but not both spouses.

Effective Date

The provision applies to any liability for tax arising after the date of enactment and any liability for tax arising on or before such date, but remaining unpaid as of such date.

The period in which an election may be made under the provision will not expire before the date that is 2 years after the date of the first collection action undertaken against the electing spouse on or after the date of enactment that has the effect of giving the spouse notice of the IRS' intention to collect the joint liability from the spouse. However, this rule does not extend the statute of limitations.

An individual may elect under the provision without regard to whether such individual has previously been denied innocent spouse relief under present law.