BILL ANALYSIS Ó SB 526 Page A Date of Hearing: July 13, 2015 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Philip Ting, Chair SB 526 (Fuller) - As Amended May 18, 2015 Majority vote. Fiscal committee. SENATE VOTE: 39-0 SUBJECT: Personal income taxes: joint returns: relief from liability. SUMMARY: Modifies the "innocent spouse" equitable relief provisions by expanding the Franchise Tax Board's (FTB) authority to relieve an individual of tax liability on his/her own income. Specifically, this bill: 1)Direct the FTB to consider the terms of a judgment of SB 526 Page B dissolution of marriage in determining whether to grant equitable relief to a spouse on income earned by, or subject to the exclusive management and control of, that spouse. 2)Specifies that the fact that a spouse's unpaid tax liability or deficiency has been revised under the judgment of marriage dissolution may be a factor weighing in favor of tax relief, even if one of the following applies: a) The spouse was not a victim of abuse at the time the return was filed; b) The funds that would have been used to pay the tax liability or deficiency were not misappropriated by the other spouse. 3)Applies to any unpaid tax or deficiency for any taxable year where a joint return has been filed, without regard to Revenue and Taxation Code (R&TC) Section 19006(b). 4)Is operative for requests for relief received by the FTB on or after January 1, 2016. EXISTING LAW: 1)Provides that, whenever a joint return is filed by a husband and wife, the liability for the tax on the aggregate income is joint and several. 2)Allows an individual who has made a joint return to seek "innocent spouse" tax relief if the following conditions are met: SB 526 Page C a) On that return there is an understatement of tax attributable to erroneous items of one individual filing the joint return; b) The other individual filing the joint return establishes that he/she did not know of, and had no reason to know of, that understatement; c) Taking into account all facts and circumstances, it is inequitable to hold the other individual liable for the deficiency in tax attributable to that understatement; and, d) The other individual elects relief within two years of the date FTB begins collection activities. 3)Limits an individual's liability for any deficiency assessed with respect to a joint return to the portion of the deficiency properly allocable to the individual if: a) At the time of election, the individual is no longer married to, or is legally separated from, the person with whom that individual filed the joint return; or, b) The individual was not a member of the same household as the person with whom the joint return was filed at any time during the 12-month period ending on the date the election is filed. 4)Authorizes the FTB to relieve an individual of liability on equitable grounds, if relief is not available under the provisions set forth above. 5)Provides that any individual who has been granted "innocent spouse" relief under Internal Revenue Code (IRC) Section 6015, relating to joint and several liability with respect to a federal joint income tax return, shall be eligible for state relief if all of the following conditions are satisfied: SB 526 Page D a) The individual requests relief; b) The facts and circumstances that apply to the understatement and liabilities for which relief is requested are the same facts and circumstances that applied to the understatement and liabilities for which the individual was granted relief under IRC Section 6015; and, c) The individual seeking relief provides the Franchise Tax Board (FTB) with a copy of the federal determination granting relief. 6)Specifies that these relief provisions shall not apply if the other individual who filed the joint return submits specified information to FTB indicating that relief should not be granted. 7)Provides that, if the individual seeking relief demonstrates to FTB that a federal request for relief has been filed with the Internal Revenue Service (IRS) and demonstrates that the federal request for relief involves the same facts and circumstances as the request pending before FTB, then FTB may not deny relief with respect to that request until action on the federal request is final. 8)Allows a taxpayer to appeal FTB's decision on an "equitable relief" request for innocent spouse relief. FISCAL EFFECT: Unknown, but may be substantial. COMMENTS: 1)The Author's Statement . The author has provided the following statement in support of this bill: SB 526 Page E "According to members of the Board of Equalization (BOE), the BOE has adjudicated a number of appeals from the Franchise Tax board (FTB) that have involved taxpayers who believed they had successfully divided assets and debts, including tax liabilities, in a divorce agreement. Current law does not allow the FTB, and by extension the BOE in its quasi-judicial function, to rely on a marital settlement agreement to relieve a spouse of a joint income tax liability unless the agreement meets a number of technical conditions contained in Revenue and Taxation Code Section 19006(b). "SB 526 grants the FTB the authority to consider a divorce agreement as a factor weighing in favor of granting relief when a taxpayer requests that the agency assign outstanding tax liabilities to the spouse who agreed to pay them, rather than holding both parties jointly liable. "The current law forces the spouse requesting relief to return to court in order to have the marital settlement agreement enforced. After negotiating a fair division of assets and debts, taxpayers are surprised when they learn that their agreement will not be honored by the state government. By providing the FTB the ability to abide by the agreement that was negotiated between spouses, this would limit additional needless litigation in both the courts of California as well as appeals to the Board of Equalization." 2)Arguments in Support . The proponents state that this bill would authorize "California tax agencies to abide by divorce judgments assigning liability to one spouse or the other, without the imposition of onerous requirements." The proponents believe that providing relief to the non-assigned spouse would strengthen the enforcement of divorce judgments and would permit an equitable result if the assigned spouse failed to pay. The proponents of this bill argue that authorizing the FTB "to consider divorce agreements when granting equitable relief, even when the agreements do not meet the requirements of Section 19006(b), will reduce the amount of additional litigation - as well as appeals brought SB 526 Page F before the BOE." Finally, the proponents urge consideration of expanding the class of judgments to include "Legal Separations and Judgments for dissolution of Registered Domestic Partnership." 3)Background: "Innocent Spouse" Relief : Under both federal and state law, spouses who file a joint tax return are individually responsible for the return's accuracy and for the full tax liability for that tax year. This concept, referred to as "joint and several liability," can inequitably impact one spouse in particular circumstances. Consequently, both the federal government and the state have enacted "innocent spouse" legislation. These provisions allow taxpayers, under specified circumstances, to be relieved of some or all of the responsibility for a joint tax debt. a) Federal "Innocent Spouse" Law : The IRS Restructuring and Reform Act of 1998 (1998 Act) made innocent spouse relief easier to obtain. Specifically, the 1998 Act allows an innocent spouse to qualify for relief under any of the following three provisions: i) Understatement/Apportionment : A spouse may request relief for a taxable year to the extent the liability is attributable to an assessment of tax exceeding the amount reported on the return (i.e., an 'understatement of tax'). Generally, the requesting party must show that the understatement resulted from an erroneous item, such as an omission of income or an overstatement of deductible expenses. In addition, the taxpayer must show that, at the time the return was signed, he/she did not know and had no reason to know of the erroneous item that caused the understatement. If the taxpayer can show lack of knowledge with respect to a portion of the understatement, the taxpayer may be relieved of liability for the tax attributable to that portion of the understatement. ii) Separate Liability Election : A requesting spouse SB 526 Page G may elect to be taxed as though he/she filed a "married filing separate" tax return. This relief is available to taxpayers who are no longer married, are legally separated, or who have lived apart from their spouse during the 12-month period preceding the request for relief. iii) Equitable Relief : An individual who does not qualify for the relief specified above may still obtain relief if, after taking into account all the facts and circumstances, it is determined to be inequitable to hold the individual liable for any unpaid tax or any deficiency. However, even under equitable relief, the income tax liability from which the requesting spouse seeks relief generally must be attributable to an item of the non-requesting spouse or an underpayment resulting from the non-requesting spouse's income. The IRS, nonetheless, will consider granting equitable relief even though the deficiency or underpayment may be attributable in part or in full to an item of the requesting spouse (a) in the case of abuse prior to the time the return was filed or (b) where funds that would have been used to pay the tax or deficiency were misappropriated by the non-requesting spouse. The IRS has issued guidance for taxpayers seeking equitable relief from joint income tax liability. In general, a nonexclusive list of factors is applied in determining whether relief should be granted because it would be inequitable to hold a requesting spouse liable. One of the factors is the existence of a legal obligation arising from a divorce decree or other legally binding agreement. It will weigh in favor of relief if the non-requesting spouse has the sole obligation to pay the outstanding income tax liability pursuant to a divorce decree or agreement. However, this factor will be only neutral if the requesting spouse knew or had reason to know, when entering into the divorce decree or agreement that the non-requesting spouse would not pay the income SB 526 Page H tax liability.<1> b) State "Innocent Spouse Law" : In 1999, California conformed to portions of the 1998 Act by enacting the Taxpayers' Bill of Rights Act of 1999. In addition, California provides two avenues for innocent spouse relief not available under federal law: i) The liability may be revised by a court in a proceeding for dissolution of marriage, under specified circumstances; and, ii) A taxpayer may seek relief from FTB on any unpaid self-assessed tax liability on a joint return, including penalties and interest. Thus, unlike the federal "innocent spouse' provisions that consider a legal obligation under dissolution of marriage as one of many factors, the state law provides that the liability may be revised by a court in a proceeding for dissolution of the marriage, and thus creates an independent exception to the general rule of joint and several liability. The FTB will grant relief to the requesting spouse provided the court order does not relieve the requesting spouse of tax liability on income earned by, or subject to the exclusive management and control of, that spouse. In the case the gross income reported on the tax return exceeds $150,000 or the amount of tax liability relief exceeds $7,500, the requesting spouse must also obtain from the FTB and file with the divorce court a tax revision clearance certificate. A taxpayer has the right to appeal FTB's decision on a request for equitable innocent spouse relief. --------------------------- --------------------------- <1> Internal Revenue Bulletin: 2003-32, Rev. Proc. 2003-61. SB 526 Page I SB 526 Page J 4)What is the Problem ? In a recent BOE case,<2> the taxpayer appealed FTB's denial of equitable relief for past unpaid taxes. The taxpayer requested the "innocent spouse" relief and submitted a copy of the marital settlement agreement that had assigned all of the couple's California tax debts (including the ones arising from the taxpayer's own income) to the taxpayer's former spouse. The FTB determined that the taxpayer failed to qualify for the equitable relief under R&TC Section 18533(f). Furthermore, the FTB stated that the court order submitted by the taxpayer did not comply with the applicable statutory requirements to provide an independent ground for relief under R&TC Section 19006(b). The taxpayer argued that the divorce settlement between her and her husband allocated the obligation to pay delinquent taxes to him, so she should be absolved of any tax debt. The FTB, however, relied on R&TC Section 19006(b), which specifically prohibits a court, in a proceeding for dissolution of the marriage, from relieving a spouse of tax liability on income earned by the spouse, or income subject to the exclusive management and control of the spouse. While R&TC Section 19006(c) expressly authorizes the FTB to revise the unpaid tax liability, it similarly prohibits the FTB from relieving a spouse from tax liability on income earned or exclusively controlled by the spouse, among other conditions.<3> Currently, there is no legal avenue for the BOE to provide relief to taxpayers under Section 19006(b). Consequently, the BOE sustained the FTB's action regarding the taxpayer's liability attributable to her income because the court order presented by the taxpayer did not comply with the requirements of Section 19006(b). Furthermore, no relief was allowed for --------------------------- <2> In the Matter of the Appeal of: TONJA M. JARRELL, Case No. 571357, BOE, 2014 Cal. Tax LEIXS 178, May 22, 2014. <3> Section 19006(c) prescribes an additional requirement before the tax liability may be revised by the FTB, namely, that the spouse whose liability is to be revised must establish a lack of knowledge of the nonpayment at the time the return was filed. SB 526 Page K the tax liability attributable to income earned by the taxpayer because she failed to satisfy the necessary conditions for equitable relief from that liability under R&TC Section 18533(f). However, the BOE granted the "innocent spouse" relief to the taxpayer as to the portion of the couple's tax liabilities that was attributable to the taxpayer's former spouse. 5)What Would This Bill Do ? This bill creates an exception to R&TC Section 19006(b) that currently prohibits a court as well as the FTB from relieving a spouse of the tax liability on income earned or controlled by that spouse. Specifically, this bill provides that, for purposes of determining whether an individual qualifies for the "innocent spouse" equitable relief under R&TC Section 18533(f), the fact that the individual's liability for unpaid taxes or deficiency has been revised under a court's judgment of dissolution of marriage may be a factor "weighing in favor" of that individual. In other words, the FTB may (or may not) consider a divorce agreement when grating equitable relief even if the agreement does not comply with the requirements of Section 19006(b). Thus, the individual may be relieved by the FTB of the tax liability attributable to his/her own income if the judgment reassigns this liability to the non-requesting spouse. 6)" Weighting in Favor of Relief:" Non-Conformity ? Divorce settlements result from often difficult negotiations between two former spouses to allocate their former joint assets and liabilities, which often involve tax debts. This bill provides that the FTB may consider a court judgment revising the individual's liability for any unpaid tax or deficiency as a factor weighing in favor of relief from tax liability on income earned by the individual. Under federal law, in determining whether equitable relief should be granted to a requesting spouse, the IRS will SB 526 Page L consider the existence of a legal obligation arising from a divorce decree or other legally binding agreement. As discussed, this factor will weigh in favor of relief if the non-requesting spouse has the sole obligation to pay the outstanding income tax liability pursuant to a divorce decree or agreement. However, this factor will be only neutral if the requesting spouse knew or had reason to know, when entering into the divorce decree or agreement, that the non-requesting spouse would not pay the income tax liability. In contrast, SB 526 does not differentiate between the spouses who knew and those who did not know. Furthermore, IRS's recent guidance indicates that it will grant relief on the requesting spouse's own income in cases of abuse or misappropriation of funds. In contrast, this bill will apply in cases where no abuse or misappropriation of funds occurred. As such, this bill's approach substantially deviates from the federal statutes and regulations, taking California out of conformity with the federal tax laws. 7)"Revising" a Judicial Order . Under existing law, a court order, in a proceeding for marriage dissolution, must separately state the income tax liabilities for the taxable years for which revision is granted. Taxpayers with income above a specified amount also must obtain a tax revision clearance certificate from FTB to give to a court issuing the divorce settlement, detailing the amounts of tax, interest, and penalties due to ensure this information is incorporated into the settlement. Under this bill, FTB or BOE are authorized to grant the requesting spouse equitable relief merely by showing that the settlement agreement revised any unpaid tax, thereby shifting the obligation from the requesting spouse to the other one, regardless of the taxable year. Spouses could then seek to reassign tax debts on their own income for specific taxable years to their former spouses, when the divorce settlement only speaks in more general terms about tax debts from income generated by one spouse or the other, or both, without being specific to the taxable year. Additionally, this bill does not compel notification to the other spouse, or grant him or her opportunity to comment, which innocent spouse relief provisions currently require. SB 526 Page M The Committee may wish to consider whether a tax agency should have such a broad authority to revise the terms of a previously settled divorce agreement. 8)Following the Law (or Not) . As noted, existing law allows taxpayers to have the liability revised by a court proceeding for dissolution of marriage. However, existing law is very clear in that it prohibits a court from relieving a spouse of tax liability on income earned or control by him/her. To the extent that the court follows all of the statutory requirements of R&TC Section 19006(b), the order itself will provide an independent ground for innocent spouse relief. Presumably, in reassigning the spouses' tax liability, a court strives to comply with the existing statute. But if a court does not follow this law, then its order will be unenforceable for purposes of the "innocent spouse" relief provisions. The supporters of this bill argue that the requirements of Section 19006(b) are onerous. However, instead of deleting these requirements to allow courts expressly to revise the spouses' tax liabilities the way they see fit, this bill appears to condone an occasional deviation by some courts from the prescribed statutory requirements in issuing divorce judgments. In particular, this bill authorizes the FBT to take into account the existence of a court order, regardless of whether or not it complies with Section 19006(b). The Committee may wish to consider whether the approach suggested by this bill is the most efficient way of achieving the intended goal of providing equitable relief to innocent spouses. 9)Slippery Slope ? Innocent spouse relief exists for tax agencies to provide relief from joint tax liabilities for taxpayers who signed joint returns with their spouses, but were kept in the dark about the other spouse's income, business interests, or financial activities. IRS and FTB grant innocent spouse relief to these taxpayers because they SB 526 Page N have no legitimate reason to know that they have a tax obligation arising from items about which they had no knowledge. Only in a few, limited circumstances has the IRS granted relief for unpaid liability on income earned by the requesting spouse, because that spouse should know that tax applies whenever he or she earns income. This bill sets a new precedent to allow the FTB, and BOE as part of an appeal of FTB's determination, to grant relief on the requesting spouse's own income in any case where the requesting spouse has a divorce agreement obligating the non-requesting spouse to pay any outstanding taxes. IRS's recent guidance indicates that it will grant relief on the requesting spouse's own income in cases of abuse or misappropriation of funds, and FTB will follow that guidance regardless of any legislative change, so this bill will only apply in cases where no abuse or misappropriation of funds occurred, setting a new precedent in the area of "innocent spouse" tax relief. REGISTERED SUPPORT / OPPOSITION: Support George Runner, State Board of Equalization, Member The Executive Committee of the Family Law Section, the State Bar of California Opposition SB 526 Page O None on file Analysis Prepared by:Oksana Jaffe / REV. & TAX. / (916) 319-2098