PRECISE LANGUAGE IN TAX INDEMNIFICATION CLAUSE COULD AVERT LATER DISPUTES – SPOUSE FOUND IN COMTEMPT OF COURT FOR VIOLATING TYPICAL CLAUSE WITH GENERAL LANGUAGE

In Brooks Lee v. Lee, 212 Ohio 373, Ohio Court of Appeals, 10th Appellate District (2012), the former husband appealed the decision of the trial court finding him in contempt on several grounds.  The case involved cross motions for contempt on various grounds but this post deals with only the former husband appellant’s fourth assignment of error dealing with the lower courts finding him in contempt for failing to abide by a tax indemnification clause in the parties’ 2001 separation agreement(SA)  later incorporated into a final judgment of divorce in October 2003.  The Final Judgment added one tax provision not in the SA, namely:

The Court finds that the parties may receive a tax refund for previously filed joint tax returns.  In the event that the parties do receive such (a) refund, the (husband) shall be awarded said refund, free and clear of all claims of the (wife).

The tax indemnification clause in the SA, incorporated into the Final Judgment provided:

Husband shall pay, indemnify and save wife harmless upon all interest, tax, penalties and attorney fees which arise from any deficiencies on any previously filed joint income tax returns.

The events giving rise to the former wife’s contempt motion began in January of 2003, when IRS sent to her a Notice of Intent to levy for an assessment in taxes, penalty and interest relating to the joint return filed for the year 1997. She incurred attorney fees to successfully obtain innocent spouse relief from IRS.  Independently, the former husband, despite the indemnification agreement, sought and was denied innocent spouse relief by IRS.  The former wife incurred additional attorney fees necessarily opposing the former husband’s request for innocent spouse relief, which in essence had challenged IRS’s granting of relief from joint and several liability to her.

The lower court found that former husband attempted to avoid his obligations under the SA. The court further found, “Rather than paying and holding…harmless for a deficiency…as was agreed, (he) challenged his liability for the deficiency.”

The lower court awarded the former wife attorney fees related to the tax liability as well as fees relating to the contempt motion.  The court sentenced the former husband to 30 days in jail but afforded him the opportunity to purge the (civil) contempt by paying the awarded attorney fees in installments.

Former husband argues that the deficiency was either caused by IRS or the former wife whose income was substantially higher than his. Further, that he never had to pay the deficiency because his taxes were discharged in bankruptcy.  The court found that former husband’s arguments “missed the mark.”  There was a final judgment and agreement that gave him the tax refunds from joint returns, made him responsible for all joint return tax liabilities and held harmless the former wife from all such tax liabilities, penalties, interest and attorney fees arising from such tax liabilities.

There are several lessons to be learned from this case:

  • Once you make an agreement, adhere to its terms, because the courts will hold you to them.
  • Seeking innocent spouse relief on its face is inconsistent with the literal terms of the terms of the Final Judgment which refers to a “deficiency.”  Since there was a notice of intent to levy served on the former, there was a deficiency which had already been assessed.  Thus, it mattered not whether, either spouse, qualified for innocent spouse relief. 
  • The ambiguity of the indemnification clause lies in its failure to address the IRS audit, deficiency and assessment procedures and to provide a process for determining:
    • What is a tax liability for which indemnification is triggered?  The clause refers to deficiency, but a deficiency may be appealed, challenged and, in fact. Litigated in Tax Court, before it is finally determined and assessed. No payment obligation arises until the tax is assessed. Deficiency is a poor trigger word for indemnification.
    • The confusion engendered by the imprecise language in the SA is continued by the court in referring to the levy being “based on a deficiency.”  Clearly, the levy was based on an assessment that followed a deficiency notice and no timely petition for redetermination being filed in Tax Court.
  • The indemnification clause should:
    • Protect against a tax loss following an assessment.
    • Provide for a process for dealing with any IRS notice and providing timely copy to the other spouse of such notices.
    • Appoint the spouse who is to deal with any IRS Audit, or correspondence, determine the correctness of IRS proposed adjustments, retain counsel, if necessary, and ultimately pay the amount, if any, determined to be owed.
    • Provide that the indemnification obligation is in the nature of support (to attempt to protect from discharge in bankruptcy) and that payments to IRS on joint return tax liabilities shall be considered non-taxable support to wife and non-deductible to husband.
    • Provide that the spouse who is giving the “hold harmless” indemnification not seek innocent spouse relief or intervene should the other spouse seek such relief.
    • Escrow the funds to pay the tax for any known potential tax liability in joint return years (such as tax shelter issues) for the period of limitations.
    • Deal with the returns to be filed for the year immediately preceding the final judgment.  If a joint return is agreed upon:

                                                  i.     Identify the agreed upon preparer and how information will be provided to the preparer.

                                                ii.    Provide a date by which a draft return shall be provided to the other spouse.

                                               iii.    Provide that the other spouse may refuse to sign absolutely, in which case, he or she shall not be required to sign, but shall pay the determined increase in tax imposed on the other spouse caused by filing as a married filing separately individual unless the refusal is found in a hearing before the court to have been due to reasonable suspicions of the other spouse not properly reporting income or improperly claiming deductions in the return or of intended tax fraud or false statements in the return. 

These suggestions are illustrative of considerations that should go into tax provisions in a marital settlement agreement.  No boiler plate language can cover the multitude of unique circumstances that arise in every divorce case.  The point is and what was lacking in the indemnification clause in this case, as drafted, was an awareness of these issues and the need to address them with cohesive and precise language geared to procedural and substantive tax law.

 

Copyright 2012 by Robert S. Steinberg
All rights reserved

 

 

This entry was posted in DIVORCE, INNOCENT SPOUSE, RETURNS, TAX, TAX INDEMNIFICATION CLAUSE and tagged , . Bookmark the permalink.

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