Innocent Spouse Injured by Using the Wrong Form

The difference between innocent and injured spouse can create confusion.  That confusion gets illustrated in the case of Palomares v. Commissioner, T.C. Memo 2014-243 which will soon be argued before the 9th Circuit by a student at the tax clinic at Gonzaga Law School.  The case illustrates something that regularly happens in innocent spouse case – the innocent spouse’s refunds get offset by the IRS to satisfy the liability of the “liable” spouse – and getting them back can prove very difficult for the innocent spouse.

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For anyone unfamiliar with the innocent spouse and injured spouse provisions, I will briefly discuss the distinction between the two types of relief.  Innocent spouse relief allows a spouse who has filed a joint return to obtain relief from the joint and several liability that results from filing a joint return if the spouse requesting relief meets certain criteria set out in IRC 6015(b), (c) or (f).  Injured spouse relief allows a spouse who files a joint return to recover the portion of the refund resulting from that return which relates to the liability of the requesting spouse when the refund would otherwise go to satisfy a tax, or other liability subject to offset, owed solely by the other spouse.  While both forms of relief result from filing a joint return, the goal of each type of relief differs and the difference can create confusion for someone who does not regularly handle these types of cases.

Ms. Palomares got confused.  She needed innocent spouse relief but filed Form 8379 designed for use by injured spouses.  The IRS recognized her confusion and provided her with the correct form, Form 8857.  Upon receipt of the correct form, Ms. Palomares eventually filed it but the delay creates the issue in the case.  The IRS determined she deserved some relief as an innocent spouse; however, the delay in filing the correct form limited that relief.  After incurring the joint liability for which she sought innocent spouse relief, Ms. Palomares found that the IRS took the refunds she claimed in subsequent years in order to satisfy the unpaid liability on the joint return.  In seeking innocent spouse relief, she also wanted a return of the refunds the IRS had offset against the joint liability.  The issue here turns on the timing of her request for refund, which turns on whether the filing of the incorrect form nominally seeking injured spouse relief can meet the requirements of the informal claim doctrine allowing her request for relief to relate to the date of filing the injured spouse relief rather than the date of filing the correct form for innocent spouse relief.

In addition to the general confusion that exists between innocent and injured spouse relief, Ms. Palomares had the additional handicap that English was not her first language, and she spoke very little English.  The years at issue for the refund are 2005 through 2008.  By these years, she had separated from her husband, and she filed returns using the filing status of head of household.  As mentioned above, the IRS took the refunds reflected on these returns as it should using the power of offset granted in IRC 6502.  When she did not receive her refunds for 2006 and 2007, she sought assistance from the Northwest Justice legal clinic which helped her fill out the wrong form on July 1, 2008.  This clinic is not a low income taxpayer clinic but a clinic providing general legal assistance.  On September 24, 2008, the IRS sent her a letter with the correct form.  The Court found that “She did not call or otherwise contact respondent with respect to the September 24 letter.”

Ms. Palomares’s life intervened and kept her from focusing on her taxes for almost two years.  Finally, in August, 2010, she filed the Form 8857 seeking innocent spouse relief with the correct form and seeking a return of the refunds taken from her for four years.  Initially, the IRS took the position that the request came too late because she sent it more than two years after collection activity had begun; however, on May 14, 2012 the IRS reversed its position regarding the two year rule and requests for relief under IRC 6015(f).  The IRS granted her relief as an innocent spouse; however, it limited her refund to amounts paid within two years of the filing of the Form 8857 in 2010.  She appealed arguing that the relief should date from the submission of Form 8379 and that is the issue before the court in this case.

The Tax Court found that the Form 8379 did not meet the requirements for an informal claim.  The requirements for an informal claim do not come from a statute since this is an equitable remedy constructed by the courts to prevent an injustice.  As the Court notes, the sufficiency of an informal claim largely turns on the facts; however, courts generally look for certain markers in deciding whether to treat something other than a formal claim for refund as an adequate informal one.  The underlying principle concerns exhaustion of administrative remedy and whether the IRS had a chance to consider the request.  The more the taxpayer can show that the inappropriate document filed essentially apprised the IRS of what it needed to know in order to grant a refund, the more likely the taxpayer will succeed.

The Court states that a qualifying informal claim must satisfy three requirements.  It quoted from a non-precedential memo opinion to set out the requirements:

It has long been recognized that a writing which does not qualify as a formal refund claim nevertheless may toll the period of limitations applicable to refunds if (1) the writing is delivered to the Service before the expiration of the applicable period of limitations, (2) the writing in conjunction with its surrounding circumstances adequately notifies the Service that the taxpayer is claiming a refund and the basis therefor, and (3) either the Service waives the defect by considering the refund claim on its merits or the taxpayer subsequently perfects the informal refund claim by filing a formal refund claim before the Service rejects the informal refund claim. Jackson v. Commissioner, T.C. Memo 2002-44, slip op. at 10.

The Court found that the Form 8379 meet the first test citing to Kaffenberger v. United States, 314 F.3d 944 (8th Cir. 2003).  The Court found that the Form 8379 did not convey sufficient information to notify the IRS that Ms. Palomares sought relief from the liability created by the joint return with her then husband and sought a refund of amounts applied to the liability created by the joint return.  The Court determined that sending her the form for innocent spouse relief amounted to guess by the IRS that she might have intended to request that relief rather than an awareness that she wanted such relief.  The Form 8379 did not reference 1996, the year for which she wanted innocent spouse relief.  Because it did not reference that year, the IRS lacked sufficient clues to know exactly what she wanted and to make a determination based on her Form 8379 other than that the form she sent did not work for the circumstances of her situation since she had not filed a joint return in the years to which the form related.  So, the Court denied her claim for refund based on the date of filing the Form 8379.

Ms. Palomares presents sympathetic facts.  She clearly did not know the difference between innocent spouse and injured spouse, and neither did the clinic that assisted her with her divorce and that helped her file the wrong form.  The IRS gave her the correct form relatively quickly but she delayed filing that form because of things happening in her personal life.  She appears to deserve the refunds she seeks.    The case deserves watching as it heads into argument in the 9th Circuit because of the effort to expand the informal claim doctrine into an area of some confustion.  If the IRS loses, it will probably do so because it was nice and sent her the innocent spouse form.  The outcome turns on whether the IRS knew what she wanted to a degree that would have allowed it to make an innocent spouse determination at the time it received the injured spouse form or instead made an educated guess based on the unavailability of the relief requested on the form she submitted and the confusion surrounding these two similar but different forms of relief available to spouses.

Update on Splitting Refunds in Bankruptcy Cases

In May of 2014, I wrote a post describing the way that bankruptcy courts approach splitting refunds in the circumstance in which one spouse goes into bankruptcy the other does not and then the couple files a joint return which generates a refund.  That post has, in a surprise to me, been one of the most popular posts in terms of the number of people who have accessed it.  Last month, another bankruptcy court opined on the issue while coming at the issue from a slightly different position than in the case from the prior post.  The recent case gives me a chance to update the post and describe bankruptcy procedure regarding the automatic stay, but also to bring up the filing season issue of injured spouse.

I recently wrote on the filing season issue of superseding returns.  I hope to write soon on another filing season issue updating another popular prior post regarding offset bypass refunds.

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As a prelude to the discussion of the problem of splitting refunds in bankruptcy cases, a quick reminder of injured spouse rules will assist those facing the situation as filing season approaches.  I wrote about the injured spouse provisions in September of 2016 in the context of discussing the statute of limitations for making an injured spouse request.  In that post I noted that if a taxpayer knows at the time of filing a joint return that their spouse owes the IRS but the taxpayer does not owe the IRS, the IRS has created a form to file with the return to alert the IRS to the desire of the spouse with no liability to have their portion of the refund actually refunded rather than offset:

When someone believes they qualify for injured spouse status, they should attach a Form 8379 to their tax return. Of course, a spouse may not know that their partner has a debt which will cause an offset of refund on the joint return and may not know that they should proactively file the Form 8379 to avoid the problem.

Unlike the innocent spouse provisions which apply when the IRS determines an additional liability on a joint return, the injured spouse provisions apply when one of the spouses already owes the IRS a liability.  When a couple knows that one partner owes the IRS a liability (or any other liability subject to the 6402 offset provisions such as student loans, child custody, state tax, etc) and the couple desires to file a joint return nonetheless, usually because of the tax benefit of joint return status, then the couple should attach the Form 8379 to the return.  If the spouse who does not owe the IRS (or the other offset entities) had no knowledge of their spouse’s debt to the IRS (or the other offset entities) at the time of filing the joint return, then he or she can file the Form 8379 when they learn of the problem which will generally occur not too long after the filing of the return because of the failure to receive the anticipated refund.  The outside time period for making the request, is discussed in the prior post.

While the IRS has issued rulings and a form making the path to injured spouse relief from the IRS relatively straightforward, the path takes on a different form if the fight over the refund occurs outside of the IRS.  Outside of the IRS, the fight over the refund usually takes place in a bankruptcy court or a domestic relations court.  The IRS rules regarding the splitting of the refund do not bind these courts but do provide context for deciding how to do so.

In the recent case of In re Nevins No. 15-10003 (Bankr. N.H. December 23, 2016), the application of the rules came up in a fight between the debtor and the IRS, rather than the debtor and the debtor’s spouse or the debtor and the bankruptcy trustee, in the context of a potential violation of the automatic stay.  Mr. Nevins filed a voluntary chapter 13 petition on January 4, 2015.  The court confirmed his plan on March 18, 2015, a normal time period between filing and confirmation of the plan.  The plan provided for payment of the IRS claim under terms that varied depending on the different types of claims held by the IRS.  In a twist on the injured spouse situation, Mrs. Nevins, who did not join her husband in filing bankruptcy, did also owe the taxes.  So, the Nevins case does not involve an injured spouse claim although the analysis applied here could also apply in an injured spouse context.

Married couples can make an election when filing bankruptcy to file a joint bankruptcy or to have just one spouse file bankruptcy.  Like the tax code, the bankruptcy code does not dictate the filing of a joint bankruptcy petition just because of marriage.  If one spouse files bankruptcy, the automatic stay of bankruptcy code section 362 applies to that spouse but not necessarily to the other spouse.  Bankruptcy code section 1301 does create a stay that can cover the non-filing spouse in chapter 13 cases; however, this stay only applies to consumer debts and the definition of consumer debt does not include taxes.

So, when Mr. Nevins filed bankruptcy and Mrs. Nevins did not, she remained exposed to the full panoply of collection weapons available to the IRS while he fell under the shield of the bankruptcy code.  In this case, the issue of offset involves not only the shield of the bankruptcy code but also the ultimate impact of discharge.  Most of the liabilities owed by Mr. Nevins fell into the general unsecured claim category.  He owed slightly over $40,000 but the IRS claim and the chapter 13 plan classified about $32,000 of that debt as general unsecured debt.  General unsecured debt is the worst type of debt a creditor can hold.  In Mr. Nevins’ plan he proposed to pay about 2% this debt.  This means that over the five year life of his plan he would pay the IRS about $640.00 and the balance of the debt would go away upon completion of the plan together with all of the interest and penalties on the debt.  For Mrs. Nevins, however, the full amount of the debt continued to exist and continued to accrue interest and, possibly, penalties.

This situation provides the IRS with an incentive to take the joint refund and apply it to Mrs. Nevins’ debt.  The automatic stay prevented the IRS from applying it to his debt since it must take payment through the plan on his debt.  The IRS calculated how much of the $1,293.00 refund each party should receive.  It determined that using its formula for allocation of refunds Mrs. Nevins should receive the entire refund and so it offset the entire refund in partial settlement of her debt.  By doing so, it collected in one action more than his five year plan would pay on this debt.  Mr. Nevins objected, arguing that the offset of the refund violated the automatic stay because it acted as a taking of property of the estate during the period of the stay.  The IRS countered that its actions did not violate the stay since none of the refund belonged to Mr. Nevins and nothing prevented the IRS from collecting on Mrs. Nevins’ liability.

The bankruptcy court faced a situation in which it needed to decide how it should calculate the refund in order to know if the taking of the refund violated the stay.  After noting the absence of controlling precedent in its jurisdiction, the court went through the same type of analysis the Lee court had done in the case previously blogged.  It also came to the same conclusion.  It rejected the 50/50 rule as too simplistic.  It rejected the income rule because it divides the refund based on “a factor which may have very little to do with actual contributions to the total tax obligations between spouses.”  It similarly rejected the withholding rule for similar reasons, noting that it may apply anyway in cases with no credits.

This led the court to the so-called separate filings rule adopted by the IRS in the revenue procedures.  The court notes that the majority of the courts are falling in line with the separate filings rule as it does.  The court described the rule as follows:

[The Separate Return Rule] allocates the refund based on each spouse’s hypothetical individual tax liability (hypothetical liability) had the spouses filed their tax returns as married parties filing separately. First, each spouse’s contribution to total payments is determined. Second, each spouse’s share of the joint tax liability is calculated based on the ratio of that spouse’s hypothetical liability to the sum of both spouses’ hypothetical liabilities. Each spouse owns that portion of the joint refund equal to the amount by which his or her contribution exceeds his or her share of the joint tax liability.

Because it lacked all of the facts necessary to rule on the precise disposition of the refund, it reserved the ruling on the outcome for another day.  The case caused the bankruptcy court to spend lots of energy over a $1,293 refund but a decision that sets precedent should the issue arise again.  If the IRS correctly calculated the refund based on the separate filings rule, the offset will stand.  If it did not, in whole or in part, some of the refund will come into the estate to satisfy the liability of Mr. Nevins under the plan and the IRS will potentially face damages for violation of the automatic stay.  I suspect any damages here would be small but it is a risk for the IRS anytime it takes money that arguably belongs to a bankruptcy estate.

Special Statute of Limitations for Injured Spouse Relief

On May 19, 2016, the Treasury Inspector General for Tax Administration issued a report entitled “Injured Spouse Cases Were Not Always Timely Resolved, Resulting in the Unnecessary Payment of Interest.”  We have not written much about injured spouse relief.  So, I thought the report might provide a good opportunity for discussing this distant but often confused cousin of innocent spouse relief.  I previously wrote about this topic in connection with individuals filing bankruptcy.

Innocent spouse relief, the better known spousal relief provision allows one spouse to remove all or part of a joint liability created as a result of a valid joint return because the requesting spouse meets the criteria set for in IRC 6015(b), (c) or (f). Injured spouse relief does not relieve the injured spouse of the joint liability on the return but allows the requesting spouse to obtain the return of the portion of the joint refund taken to offset a debt of the non-requesting spouse.  The injured spouse will have contributed some portion of the payment of the tax through withholding or estimated payments which the IRS will use to satisfy a pre-existing debt of the other spouse for federal taxes or some other debt allowed under the offset rules of IRC 6402.

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For example, Harry and Sally file a joint return. Harry has a child support obligation that pre-dates his marriage to Sally and some of the child support remains unpaid.  The child support agency properly certifies the debt to the IRS and the IRS computer is posed to offset any refund due to Harry.  Harry and Sally file a joint return.  Harry did not work that year but was a stay at home dad.  Sally made $100,000, creating a tax liability of $15,000 on their joint return and she had withholding of $21,000.  The IRS will take the $6,000 refund and use it to pay Harry’s child support obligation from his prior marriage.  This may cause marital friction between Harry and Sally.  The injured spouse provisions allow Sally to obtain a return of the money she paid into the IRS, here the entire $6,000, and to reduce the marital friction.  Sounds simple and easy but you know that things do not always work out that way and TIGTA studied the process to see where the pressure points might be.  In reading their study, I learned an unusual fact about the statute of limitations for claiming injured spouse status.

The TIGTA report states that a spouse can qualify for injured spouse status if that person is not required to pay the past due amount that the IRS offsets under IRC 6402 and meets any of the following criteria:

  • The injured spouse made and reported tax payments (e.g., Federal income tax withholdings from his or her wages or estimated tax payments).
  • The injured spouse had earned income (e.g. wages, salaries, or self-employment income and claimed the earned income credit or the additional child tax credit.
  • The injured spouse claimed a refundable tax credit, such as the premium tax credit or the refundable credit for prior year minimum tax.

When someone believes they qualify for injured spouse status, they should attach a Form 8379 to their tax return. Of course, a spouse may not know that their partner has a debt which will cause an offset of refund on the joint return and may not know that they should proactively file the Form 8379 to avoid the problem.  Sometimes, the failure to know this and the delivery of the news in the form of an IRS notice explaining where the refund went can cause confusion for the unrepresented taxpayer who will not always know about the ability to claim injured spouse relief.  When the Form 8379 does not accompany the return, the injured spouse can file it after the fact by submitting a paper copy of the form to the service center where the return was filed.  In each of the calendar years 2014 and 2015 over 360,000 injured spouse claims were filed according to a table in the TIGTA report.

The TIGTA report explains the processing of the injured spouse claims. Some claims do not fit the criteria and the IRS rejects them.  Some cases require additional verification.  Most cases do not involve the clean payment of everything by the injured spouse as occurred in my example with Harry and Sally above.  So, a computation showing who paid what and who made what is necessary in order to allocate the payment of the refund between the two parties.  Usually, the husband and wife will both be working toward the same goal of maximizing the injured spouse claim but sometimes the interest of the parties may have diverged by the time of the injured spouse claim.  It is even possible that the need to use the injured spouse claim process could have exacerbated the situation and caused competing interests.

The IRS is supposed to process the injured spouse claim within 45 days. This is the normal time the IRS has to process a return or refund claim in order to avoid interest.  The 45 day period is measured from the later of:]

  • The due date of the return (determined with regard to any extension of time for filing the return).
  • The date the tax return was received (used when the return is filed after the return due date, determined without regard to any extension of time for filing the return).
  • The date the tax return that could be processed was received (date the tax return was received in a complete and processable form).

The IRS does not like to pay interest to taxpayers because it has delayed in processing a submission so it measures the number of cases on which it must pay interest and generally regards these cases as system failures. TIGTA runs reports like this to measure IRS effectiveness in meeting its goals.

TIGTA found that 91% of the injured spouse cases were accurately processed and seemed pretty satisfied with that result. It also found that 30% of the cases did not meet the processing time frame resulting in interest due to the injured spouse.  TIGTA did not seem satisfied with that result.  The TIGTA report goes into some detail about the reasons for the missed deadlines and how the process might be improved.  I will not recount that information.  I think the report gives a reader some idea of what to expect when you make an injured spouse request.  The fact that the IRS misses the 45 day time frame on 30% of the cases did not surprise me.  When you are advising your client of what to expect if you are caught up in the process, the data may be useful as you make that explanation.

The part I found most interesting was on page 9 of the report where TIGTA chastised the IRS for not making changes in a report it produced in 2004 which was apparently the last time it looked at injured spouse claims. The earlier report had recommended that the IRS provide taxpayers with “consistent information necessary to ensure that they can easily and correctly comply with injured spouse claim requirements.”  In this regard TIGTA noted that the IRS does not inform taxpayers that they have six years to make a claim for injured spouse relief when the IRS takes the money and applies it to a “non-tax debt” which I think means a non-IRS debt because some of the money goes to pay state taxes.  The report points out that taxpayers have three years to file a claim if the money is offset to a tax debt.

The IRS did a nifty job of blaming its lawyers for failing to give clear guidance on the law. TIGTA countered that the IRS took seven years after receiving the unclear guidance before it asked Chief Counsel to clarify its guidance.  No matter who is at fault, I learned something new in reading this and finding out that there was a six year statute for claiming injured spouse status for refunds applied to non-tax debt.  I do not know if I will ever use this information.  I think it is information that is best put into the hands of return preparers who see the taxpayers at a time when they can avoid the problem by filing the form with the return and who see a lot more taxpayers than those of us doing controversy work.

When one spouse owes a debt that the couple knows will be offset, the couple has to make a decision at the time they file their return. I have talked to a number of spouses married to someone with such debt who refuse to file a joint return because of the existence of the debt.  This refusal causes them to miss out on many benefits available to those who file joint returns.  Using  the injured spouse relief provisions may cause a few more problems in filing the return, may slow down the refund a bit but a joint return may yield thousands of dollars in tax benefits lost by using the married filing separate filing status.  These provisions should be part of a discussion by return preparers and tax planners.  The report helps to demystify the process and for that reason is worth the read.

Summary Opinions for 6/13/14

Week late, and more than a buck short, here is last week’s Summary Opinions.  This week had a lot of really interesting procedure items, including the Clarke summons case being decided by SCOTUS, which Les covered here, and the final Circ. 230 regulations, which Michael Desmond covered for us here.  I still have my disclaimer in my email auto-signature.  Have to get around to that someday.

We also had the pleasure of welcoming Professor Andy Grewal (great professor, excellent scholar, but, most importantly, he named “Summary Opinions”) as a guest poster, where he discussed TEFRA jurisdiction and sham partnerships.   Thanks to both our guest posters.  As always, I will blame that wonderful content for bumping Summary Opinions all the way to the end of the week (but in reality, my day job got in the way).

So what happened last week that wasn’t covered?  A lot of really interesting stuff.  Here you go:

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  • Jack Townsend’s Federal Tax Procedure Blog and Federal Tax Crimes Blog had a nice write up of US v. Carlson, which reviewed the plaintiff’s liability for the Section 6701 aiding and abetting understatement penalty.  Jack’s post focuses on the government’s standard of proof, which the 11th Cir. said was clear and convincing.  Jack follows that up with a good discussion on extending this rationale to FBAR willfulness.

 

  • Hom getting tired of coming up with bad puns for Mr. Hom (not really, I love them).  So, our favorite online gambler/tax procedure renegade, John Hom, lost yet another tax procedure case in district court.  Mr. Hom had accounts with various online poker companies outside of the US, which Mr. Hom failed to disclose on timely filed FBARs.  Mr. Hom contested the filing requirements and penalties by arguing the accounts weren’t bank accounts or other financial accounts.  The court quickly dispatched these claims by indicating the accounts fall within the definitions.  Best/worst line from case,  “The Court has tried to appoint a free lawyer for defendant—but no one would take the case.”  This was done probably because the issue was novel, and potentially far reaching.  Jack Townsend has a strong write up of the case here.  If the online poker account is the equivalent of a bank account, how far does the statute reach?

 

  • Our hammer lobbing (if you actually read all of our comments, that may make sense, otherwise it’s an inside joke, which I’ll try not to do often) frequent reader/commenter, Bob Kamman, tipped us to YRC Regional Trans v. Comm’r, which is a refund jurisdiction case, where the Tax Court told the Service to scram – because procedure says so.  The facts are somewhat complicated, as this is an NOL refund involving an acquisition where the target company’s subsequent NOL was carried back to the purchaser’s prior tax years.  But, boiled down, YRC had an NOL for 2008.  That was carried back for a tentative refund for 1999 on the purchaser’s books.  IRS issued a refund check on Sept. 30, 2009 for $351k and change.  Both parties agreed that was a rebate refund under Section 6211(b)(2).  On April 2, 2010, the Service issued another check in a similar amount of $357k and change. Taxpayer said thank you very much and deposited the second check.

 

Simple so far, but this will require a second paragraph.  Sometime later, the Service decreased the 2008 NOL, resulting in the 1999 carryback refund decreasing by around $64k.  The Service then increased that deficiency by the second erroneous refund amount.  What is really at question is whether or not the second refund was a rebate refund or a nonrebate refund, and how the Service can go about recovering each.  The Court has a good discussion on this point.  Essentially, an IRS error in issuing two refunds, regardless of the underlying reason, is a nonrebate refund.  Nonrebate refunds can only be obtained under Section 7405 procedures, which the Tax Court has held it does not have jurisdiction over.  Assuming the Service is not time barred, they could bring this in other federal courts.  In addition to bringing this suit in the appropriate courts, the Service also takes the position that it can offset this type of nonrebate erroneous refund against future refunds (based on common law principals, not the Code). See CCA 200137051.  I have never looked into that issue, and would not agree to that position until I had researched it further.  I believe Keith is going to write some additional commentary on this, and another erroneous refund case from last week that was brought to our attention by a good friend to the blog.

 

  • In Ruscitto v. U.S., an MJ recommended summary judgment in favor of the feds in a case where the income tax refund of a husband and wife was applied against hubby’s TFRP.  Wife argued that a portion of the refund was due to her, as her income from her Form 1099-C (cancellation of debt) gave rise to a portion of the income.  The Court found the claim was untimely, and could not review the claim.

 

  • SCOTUS has held that inherited IRAs are not retirement funds under 11 USC 522(b)(3)(C), meaning they are not exempt from the bankruptcy estate.  See Clark v. Rameker. Keith hopes to provide insight on this in the coming days or weeks.

 

  • In honor of Fathers’ Day, Going Concern has a post about paternity leave.  My wife has always given me a hard time about how long I took off after each of our daughters was born.  She claims cumulative total, I took off one day.  Two months ago she found out my firm has a paid paternity leave of six weeks…she was not thrilled.

 

  • I should have asked Keith about this case before writing it up, as his knowledge of taxes and bankruptcy is far superior to mine, but In Re: Pugh struck me as interesting.  In the case before the Eastern District of Wisconsin Bankruptcy Court, the debtor entered into Chap 13 bankruptcy (keep your assets, but have to pay your debts over 5 years), and entered into a repayment plan on July 30, 2013.  The Chap 13 plan provided that the debtor “would retain any net federal and state refunds”.  Following the plan, the Service audited the debtor’s 2011 return, resulting in a deficiency which was provided to the court.  The debtor then filed a 2013 return, requesting a refund, which the Service used to offset against the 2011 deficiency.  The taxpayer took exception, since the plan said she was to receive refunds and the 2013 tax year occurred after the filing of the bankruptcy petition.    The Court noted that when the debt and refund are both prepetition, the Service does not need to seek relief from the automatic stay; however, here the refund was post-petition.  The Court highlighted the split on this issue, with some courts holding the Service has the right to offset under Section 6402(a), leaving the “net refund” to be calculated after the setoff.  Others have held Section 6402 does not lift the stay, and the assets must pass to debtor or, at the least, the Service must ask permission before making an offset such as this.  The court in Pugh sided with the first set of cases, holding the power under the Code trumped the bankruptcy stay.  These cases seem to arise somewhat frequently.  I suspect we will see some additional Circuit Court guidance in the near future.

 

When One Spouse Files Bankruptcy How Should the Court Split the Refund Resulting from a Joint Return between the Estate of the Debtor Spouse and the non-Debtor Spouse

The issue of splitting a refund between spouses comes up both inside and outside of bankruptcy.  Regularly, one spouse will owe the IRS while the other does not.  The spouses find it beneficial to file a joint return or they do so reflexively and the issue of the use of the refund to satisfy the liability of the one spouse immediately arises because the IRS will offset the refund to the debt of the liable spouse.   The offset in this situation can create an injured spouse situation for the non-liable spouse.  The non-liable spouse must take action to obtain the portion of the tax refund to which they are entitled.  I intend to write more on injured spouse relief soon to discuss a recent program manager technical assistance memorandum.  The discussion in this post centers on the issues the couple will face in bankruptcy rather than the issues they face with the IRS.  Essentially, the same problem faces them in bankruptcy that they confront as a result of IRC 6402.  The bankruptcy trustee wants to use all, or as much as possible, of the refund to pay debts of the spouse who filed a bankruptcy petition.  The spouse who did not file bankruptcy wants to keep as much of the refund as possible.  The issue facing bankruptcy judges is how to split the refund between the parties.

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The IRS has issued a series of Revenue Rulings setting out its position on how to split a refund of a joint return.  Its initial ruling, Rev. Rul. 74-611 was modified by Rev. Rul. 80-7, which provides the general rules still applicable today.  Rev. Rul. 80-7 has been clarified by several rulings which apply it to refunds arising for individuals living in community property states.  See Rev. Rul. 87-52 (Describing the application in community property states).  The application to community property states became very specific in 2004 with the adoption of a series of rulings. Taxpayers domiciled in Arizona or Wisconsin should refer to Rev. Rul. 2004-71; taxpayers domiciled in California, Idaho, or Louisiana should refer to Rev. Rul. 2004-72; and taxpayers domiciled in Nevada, New Mexico or Washington should refer to Rev. Rul. 2004-73.  Rev. Rul. 2004-74 (Special rules for Texas community property).

Essentially, the Rev Rul 80-7 calls for allocating the refund between the spouses by calculating each spouse’s share of the joint overpayment and then determining the difference between each spouse’s liability and each spouse’s contribution. The overpayment credited to a spouse in the spouse’s individual capacity cannot exceed the joint overpayment.  For example, if H stayed at home while W earned all of the income in the household and if the refund on the return resulted from withholding on W’s salary, the refund would go to W under the Rev Proc.  If W was the spouse who owed the tax, the IRS could offset the entire amount.  If H was the spouse who owed the tax, the IRS would send the entire refund to W.  The Rev. Rul. Seeks to allocate the refund as if the spouses had filed separately while recognizing that they receive the benefit of filing a joint return (assuming it was a benefit.)

The result set out in Rev. Rul. 80-7, or any of the related rulings, does not necessarily follow if the refund occurs in a bankruptcy context.  A recent case highlights the different ways that bankruptcy courts have chosen to deal with this situation when only one of the spouses files a bankruptcy petition but the spouses file a joint tax return which generates refund.

In Lee v. Walro, the bankruptcy court faced the situation of a refund generated by a joint return where only one spouse filed a bankruptcy petition.  Mr. Lee filed a chapter 7 bankruptcy petition on January 3, 2012.  Brenda Lee, his wife – no known relation to the famous country singer, did not.  They filed joint federal and state returns for 2011 on October 1, 2012, reflecting a $25,000 refund due to them from the IRS and $5,751 refund due from Indiana.  The bankruptcy trustee filed a motion seeking half of each of these refunds.  Mr. Lee objected arguing that the entire refund resulted from estimated payments made by his wife.  The facts do not appear contested on this point.  The issue turns on the legal effect of filing the joint return and whether the bankruptcy estate may recover all or a portion of that joint return even if it resulted from payments by the spouse who had not filed bankruptcy.  Because no statute controls this situation, courts facing such an allocation, typically bankruptcy or domestic relations courts, are free to craft their own remedy and do not need to follow the administrative practice that the IRS has adopted in its revenue rulings.

The bankruptcy court applied the minority approach – the so called 50/50 rule – and divided the refund equally between the spouses awarding half to the trustee on behalf of the husband in bankruptcy.  Mr. Lee appealed that decision to the district court which decided this case.  The district court noted that bankruptcy courts had developed three distinct lines of authority for deciding this issue.  It noted that the 50/50 rule followed domestic law and provided an easy to administer bright line test.  See In re Page, and In re Aldrich.  The second method, and the one adopted by the majority of the bankruptcy courts facing this issue utilizes calculations that split joint tax refunds proportionately.  While this approach had some variations, it generally involves allocating between spouses based on withholding during the relevant tax period.  See In re Kelinfeldt and In re Gleason.  The third approach, known as the Separate Filings Rule or Internal Revenue Service Formula, requires a determination of each spouse’s contributions and tax liabilities before applying that proportion to the joint tax refund.  See In re Crowson.

The district court rejected the trustee’s argument that the refund should be split 50/50.  That argument principally relies upon the joint and several liability of each spouse for debts on the return but it does not take into account the source of the refund.  In making this argument the trustee also relied upon state law which treats property acquired during marriage as joint property but the bankruptcy court rejected this because Indiana is an equitable distribution state which seeks to divide property acquired during a marriage in a manner that is “just and reasonable.”  The court noted that while in this case the rejection of the 50/50 rule keeps the property out of the bankruptcy estate in many cases such a rule would allow a spouse who did nothing to generate the refund the benefit of a windfall to the detriment of the creditors of the estate.

Ultimately, the district court settled on the IRS formula as the best approach to determining who should receive the refund in this case.  It analyzed the formula and why it created the best method for determining whether the refund belonged to the estate or to the non-debtor spouse.  Here, it seemed clear that the refund belonged to Mrs. Lee and not to the estate.  This result not only creates consistency with the IRS and the type of fairness sought in a court of equity like the bankruptcy court but an overall sense of legal correctness.  Nonetheless, the bankruptcy court recognized the problem with this approach in some cases and left an out for trustees to come back to it with the 50/50 approach in other cases.  The problem with the IRS formula stems from the requirement to redo the tax return to calculate what each spouse should receive had they filed separately.  The cost of that calculation can, in some cases, exceed the value of the refund.  The Court reserved the option that in some cases the simpler approach of splitting the refund evenly should be adopted for that reason.

This court does an excellent job analyzing the options in this setting, the reasons behind the options and the reason for adopting the IRS approach which seems to generally be the fairest approach for splitting a refund.  The court goes further to recognize the practical problems frequently present in bankruptcy cases that getting the precisely right answer comes at a cost which can unduly burden the unsecured creditors or the trustee.  If you must split a refund in a proceeding outside the IRS, this case offers an excellent look at that process.  The dollar amounts of the refunds here tilted the balance to using the more complicated but fairer calculation adopted by the IRS.