Taxpayer Stuck in IRS’ Narrow Escape Clause

Lillian Palmer knows how the inscription should read on her tombstone: “Here lies Lillian, killed by the IRS.”

Hers is a convoluted tale that neither she nor the Internal Revenue Service can fully explain. But at the heart of it is a simple fact: Sometime after she was divorced, the IRS audited a very old tax return and determined that the Palmers didn’t pay enough tax.

Fully 10 years after the returns in question were filed, Lillian Palmer got a call from an IRS revenue officer demanding payment. It was the first she heard of the audit; it was the first she heard about the tax. Living on Social Security and the proceeds of a modest IOU, she hasn’t a prayer of paying the bill.

In theory, it appears she could win forbearance under IRS rules that absolve innocent spouses of liability--rules that Congress recently bolstered with some fanfare. But her entreaties for more information, her plea for compromise and her request to be considered an innocent--and non-liable--spouse have been ignored or rebuffed, she says.

In the meantime, IRS collection agents have twice seized her Social Security income while she was laid up in the hospital, returning the money only after her son-in-law’s accountant filed a ream of protests on her behalf.

Palmer, 79 and frail from a heart ailment, finds herself in the midst of a tax nightmare she fears she’ll escape only in death.

Worse still, the recent revamp of the Taxpayer Bill of Rights--which was supposed to expand protections for people like Palmer--is unlikely to do her any good, tax experts say. In fact, her story may illustrate just how difficult it is to qualify for aid under this little-known and poorly understood provision in the U.S. tax code.

Section 6013(e) of the code is an escape clause. Designed for people--often divorced, stay-at-home moms--who were ignorant of the family finances, it says that under certain narrow circumstances they can be absolved of tax liabilities they didn’t know about and didn’t benefit from. When the Taxpayer Bill of Rights was revamped recently, this section was bolstered somewhat, giving innocent spouses the right to know what had been done to collect the tax from the culpable spouse.

But the IRS acknowledges that it rarely officially grants innocent-spouse status. And accountants maintain that the new rules are little more than window dressing on a very unpleasant picture.

Couples that sign joint tax returns are jointly and severally (individually) liable for all the income taxes due. If the IRS audits your return and determines more money is owed, that amount can be collected from either or both members of the pair. For the most part, it doesn’t matter who made the mistake that resulted in more tax; it doesn’t matter whether you are still married; it doesn’t matter who agreed to pay the taxes in a divorce settlement. The IRS tends to collect against whomever has the money most readily accessible.

“The Taxpayer Bill of Rights now gives innocent spouses the right to know what the IRS has done to collect against the guilty party. But that doesn’t mean you can force them to go after the other person,” says Robert Nath, partner in the Fairfax, Va., law firm of Odin, Feldman & Pittleman and author of an upcoming book on dealing with the IRS. “They go after the person who has money that’s easiest to get.”

There’s one way out. If you can prove that you meet the five criteria that would make you an innocent spouse, you can be absolved of all liability.

The five tests:

* You must have filed a joint return.

* There must have been a substantial understatement of tax.

* The understatement has to have been attributable to “grossly erroneous” items.

* The innocent spouse must not know--or have reason to know--about the grossly erroneous items when the return was signed.

* And it must be “inequitable” to hold the innocent spouse liable for the deficiency.

Does Palmer qualify? She and her accountant say yes. But ask the IRS and the answer is probably not. Why?

The terms “grossly erroneous” and “substantial understatement” are narrowly defined with tests of their own that are hard to meet, says Judith Golden, an IRS spokeswoman in Laguna Niguel.

Moreover, the inequitability test has little to do with Palmer’s current financial status. It has to do with whether she benefited from the actions that resulted in the additional tax assessment. For instance, if this assessment was made because the IRS discovered unreported income and Palmer benefited from that income by living an opulent lifestyle while married, she would be unable to meet the inequitability test today.

Palmer maintains her lifestyle has never approached opulent. But the IRS doesn’t know and hasn’t yet attempted to review Palmer’s case with an eye to how she meets the innocent-spouse tests. Why? Although Palmer says she asked for innocent-spouse status immediately, there is no paperwork in her file to prove it, says Golden.

Worse yet, regardless of the paperwork, Palmer may never be able to prove she meets the test because the case is so old--and was already old when she was contacted--that many of the facts are apparently unavailable.

IRS officials have been searching for the case file for three weeks with no success. No one can explain the reason for the audit and additional tax assessment--and therefore rule on the “grossly erroneous” question--without it. Normally, cases this old are destroyed, says Golden.

Meanwhile, the collection file--a separate computerized document--is filled with gaps and notations that IRS officials acknowledge they can’t understand. The revenue officer in charge of the case says she can’t remember the details of Palmer’s situation. The IRS also has said there is no information on whether it has contacted her former husband, who lives elsewhere in California.

Now, partly because of this column, IRS managers are reviewing the case, trying to determine whether the rules can be stretched to make them more equitable in Palmer’s admittedly murky and complicated situation.

In the interim, Palmer waits.

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Kathy M. Kristof welcomes your comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls. Write to Personal Finance, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail kathy.kristof@latimes.com