For some, divorce seems like the right time to air all of the family’s dirty laundry. This may be especially true when a spouse discovers that their ex understated or ignored income on previously filed tax returns. A dependent spouse who knows about tax fraud may come to realize that unreported income will not be available to establish support payments. In either situation, there may be a strong impulse to raise these issues in court.

From bad to worse

Raising tax issues in court can create a variety of side-issues that may disadvantage both parties – a “lose-lose” outcome. At the outset, judges who are privy to this knowledge have no choice but to report fraud to the federal and state tax authorities. This is called in the divorce industry “a Sheridan problem”, named for the New Jersey opinion that established the public policy of the judiciary’s mandatory tax fraud reporting.  In addition to divorce proceedings, the accused party, and most often his or her wife, will be forced to confront legal actions related to their tax issues.  This could lead to costly civil proceedings, criminal proceedings, or both.   It also leads to heightened acrimony between the parties, contradictory accusations to the IRS, and other unpleasant consequences.

Mediation, arbitration, or collaborative divorce

To avoid airing tax issues in court, parties should focus their efforts on mediation, arbitration, or collaborative divorce. These processes can provide nuanced negotiations through which spouses may be able to persuade each other to provide support at appropriate levels that more accurately match actual income, without running afoul of reporting obligations at the level of the judiciary.

Mediators and arbitrators are not required to disclose to law authorities any past instances of understated income, but they will not knowingly tolerate plans to continue unlawful tax evasion.

I took over representation of a fellow who was so angry with his bookkeeper-wife’s after-discovered raiding of the company till that he insisted on trying his divorce case to the Family Part Judge, even though the parties had regularly underreported income on the federal and state tax returns, and both of them knew it.  The trial judge reported both of them to the I.R.S. and the N.J. tax authorities, and she directed that every dime of the parties’ marital estate be placed in escrow for more than a year, in case the taxing authorities wanted to assert and collect on their tax liens.  This was a bad outcome for everyone, and mediation followed by binding arbitration would have been a much better way for both parties to go.  This is an example of “I don’t have to love, like, or trust you, yet we are better off hanging together than being hanged separately.”

Innocent Spouse Rule

Some fear that in light of an impending divorce, their spouse’s prior tax fraud or income misstatements may create debts or even criminal liability for them. Under the law, spouses who were unaware that their exes-to-be misstated income on a previously filed joint tax return may be eligible for “innocent spouse” relief. Specifically, and under both federal and New Jersey law, parties may be entitled to recalculation of tax obligations  when they are (A) divorced,  (B) separated, or (C) living separately from the fraudulent spouse for at least 12 months — and can prove that they were not aware of the tax fraud.  However, the “innocent spouse” must be truly innocent, in that they neither knew — nor in the exercise of reasonable diligence should have known — of the tax fraud.  So, for example, a spouse who signs a joint tax return showing $25,000 of joint family income in a given tax year, but whose joint family lifestyle in that same tax year is over $200,000, is not going to succeed in asserting “innocent spouse” status.  IRS and N.J. tax authorities may have been born at night, but it wasn’t last night.

Conclusion

Since negotiations are crucial in cases in which a spouse has misstated, understated, or ignored taxable income, timely representation by knowledgeable and experienced family law attorneys is of the utmost importance.    We will bring in CPA’s and tax counsel if necessary to complete the advocacy team.

We will always adhere to the letter of the law in such matters and will never advise you to take positions outside the bounds of law and ethics.  When possible, our goal is to help you lawfully avoid the harsh glare of the judicial and tax authorities, while still resolving your divorce terms fairly and completely.

With that understanding, our law firm will discuss the facts with you confidentially, explain the law, and help you develop the best legal strategy moving forward, whether that involves filing amended returns, filing separate returns, cooperating with the tax authorities, and/or developing an alternative dispute resolution process as discussed above.

Call or write to us to set up an initial consultation.  We will be glad to help you.