Community Property, Substitute Return, and Deceased Spouse: Who is Responsible for the Tax Liability?

Overview

In community property states, each spouse is generally attributed one half of the community income. Unless a joint return is filed, this results in each spouse being liable for tax on their attributed portion of the community income. This article will explore what happens when community property is not properly allocated between married individuals due to a substitute return and one of the spouses passes away.

Generally, community property is all property acquired during a marriage while the spouses are domiciled in a community property state. Similarly, community income is income generated from community property. Items included in community income include:

In the event that a tax return is not filed by a married individual, the IRS has the ability to file a return on the taxpayer’s behalf using what is known as a “substitute for return” or “SFR” for short. Under Internal Revenue Code (“IRC”) §6020(b), if a taxpayer fails to file a return, the IRS is authorized from the information it has obtained or that is available to it. Substitute returns are based only on information reported to the IRS from other sources. Substitute returns typically overstate a taxpayer’s tax liability because the IRS only allows a standard deduction, one personal exemption, and a filing status of Single or Married Filing Separately.

The IRS will first notify the taxpayer by Letter 2566 that the IRS has no record of receiving a Form 1040. The letter proposes a tax assessment with penalties and interest based on the income reported to the IRS by third parties. If the taxpayer fails to respond, the IRS will subsequently issue a Notice of Deficiency (often referred to as the “90-day letter”). If the taxpayer fails to respond to the Notice of Deficiency within the 90-day period, the proposed tax, penalties, and interest will be assessed. If the tax has been assessed as the result of an SFR, a taxpayer can utilize the IRS’s Audit Reconsideration process to contest the SFR determination. To take advantage of the Audit Reconsideration Process, the taxpayer should file an original tax return.

If the information reported to the IRS is fully accurate and the SFR is correct, the next step would be determining how to pay the tax liability; however, what happens if the SFR was filed on behalf of a spouse in a community property state?

Typically, early in the collection process, the IRS will file a Form 668(Y)(c) with the county clerk’s office where the taxpayer lives or owns property. The Form 668(Y)(c) is also referred to as a Notice of Federal Tax Lien. In the community property states, a federal tax lien will attach to the liable spouse’s separate property. The tax lien will also attach to the liable spouse’s half interest in community property. To determine how to collect the tax, a revenue officer will go through a two-step process. The first step is to characterize all of the property available for collection as either community property or separate property. The second step is to determine whether state law creates additional property rights of the liable spouse that would cause the tax lien to attach to more than the liable spouse’s half interest in the community property.

If the taxpayers has not made payment arrangements with the IRS, the liable spouse and non-liable spouse may be subject to levy. In Texas, it is possible to serve a levy on the non-liable spouse’s salary or wages to reach the liable spouse’s community property interest. If a spouse dies with outstanding tax liability, the death of the spouse terminates the community. As a result, wages of the surviving spouse are no longer community property; thus, cannot be levied upon. In Texas, items of community property do not automatically pass to the surviving spouse. Instead, the surviving spouse maintains a half interest in the property with the decedent's estate. Items of former community property remain available to satisfy community debts as they would have before the death of the spouse and to the extent of their value at the decedent's death. Therefore, items of former community property held by the non-liable spouse or in the liable spouse’s estate may be collected to satisfy the tax obligation.

In the event that the tax liability is not paid prior to the liable spouse’s death, the estate will be personally liable for the outstanding taxes. Under IRS Publication 559, the primary duties of a personal representative of an estate are to collect all the decedent’s assets, pay creditors, and distribute remaining assets to heirs or beneficiaries. If an estate is insolvent, meaning it cannot pay all the decedent’s debts, the outstanding tax liability owed to the IRS must be paid first. If the personal representative fails to do so, the representative could be personally liable for any taxes owed that the representative had notice of such obligations or failed to exercise due care in determining if such obligations existed before distribution of the estate's assets and before being

discharged from duties. In the instant case, the article has discussed an SFR filing and the tax being assessed prior to the liable spouse’s death; thus, a personal representative exercising proper due diligence would have known about the outstanding liability. As a result, the personal representative would be liable for any payments made before paying the decedent’s tax obligation to the IRS, unless other debts paid had priority over the tax liability.