Today’s guest post is from my colleague Orli Oren-Kolbinger, a Visiting Assistant Professor at Villanova University Charles Widger School of Law. In this post, Orli discusses problems with the tax law’s failure to allow taxpayers to unwind certain elections, including the inability to change filing status from filing jointly to separately. In this post and in her longer work in progress The Error Cost of Marriage Orli suggests ways to fix the problems associated with elections. Les
This blog post seeks to explain why the ability to correct tax election errors is especially important during times of global pandemic and economic uncertainty. Focusing on married taxpayers’ filing status election, I discuss the archaic and asymmetric error-correction rule that applies when married taxpayers seek to correct a tax election after the due date has passed. I conclude by offering a solution to this problem. The following is based on my recent work-in-progress The Error Cost of Marriage. I welcome any and all comments.
A Brief Primer on Elections
United States taxpayers make many explicit elections each year. Clearly, from time to time taxpayers elect the less beneficial option to them. I refer to these inferior elections as “Election Errors.” These errors may result in additional tax liability. As previously discussed here and here, taxpayers are unable to fix an election error with a superseding return after the due date for the election has passed. They can, however, file an amended return to fix some election errors using the error-correction mechanisms set forth in the Internal Revenue Code. Nonetheless, error-correction mechanisms that are available to a taxpayer in the Code are inconsistent and at times asymmetrically applied among similarly situated taxpayers.
In addition, tax elections are “sticky.” When taxpayers face an election they have already made in the past—e.g., filing status election married taxpayers are required to make every year—they maybe cautious or resistant to such a change. Taxpayers in this situation may also fail to consider the alternative election available to them, even if the alternative would make them better off.
Taxpayer elections tend to be sticky during ordinary times, but even more so during times of economic and public health uncertainties. Consider your actions in regards to renewing your car insurance, reenrolling in employee benefits, or even ordering groceries online. You would probably prefer to avoid making significant changes to your previous elections as much as you can. This behavioral pattern can lead to errors, too, and is exacerbated during times of crises. Therefore, allowing taxpayers the option to correct an election error is a critical component of any decision-making process, including within the tax system.
The Inconsistent Approach to Fixing Election Errors
When looking to identify and classify error-correction mechanisms available to taxpayers in the Internal Revenue Code, the mechanisms available are inconsistent. Moreover, some benefit taxpayers and some do not. Hereinafter, I introduce three error-correction mechanisms that apply to married taxpayers’ filing status election. I then focus my analysis on the latter two.
Under one mechanism, the IRS initiates and corrects taxpayers’ errors for them without charging them of any fee to do so. For example, if a married taxpayer fails to file a tax return, the IRS automatically defaults them to “Married, Filing Separately” status (MFS) in the substitute return the IRS prepares.
Under a second mechanism, taxpayers can file an amended return to correct election errors. For example, married taxpayers are permitted to amend their filing status from MFS to “Married, Filing Jointly” (MFJ) after the due date for that tax year has passed, if they fulfill the requirements listed in IRC § 6013(b). When doing so, however, taxpayers produce an externality. It is an externality because the IRS now needs to reallocate resources to process an additional return for an already closed tax year only because the taxpayers previously elected an inferior alternative. Even so, the IRS does not charge a fee to process the amended return, despite its limited resources. As a result, taxpayers do not internalize the cost of correcting that election error. Moreover, this mechanism allows married taxpayers to receive a late tax refund—or at least a non-monetary or declaratory benefit (e.g., in the case of same-sex marriage)—for a closed tax year. Otherwise, taxpayers will not pursue it.
Under a third mechanism, taxpayers are not permitted to correct their election errors. For example, given the language of IRC § 6013(b) married taxpayers cannot change their filing status from MFJ to MFS, although the latter is the default filing status for married taxpayers. The only exceptions are “innocent spouse relief” under § 6015 and if the MFJ election is void (e.g., if the taxpayer is not eligible for this status), which are different scenarios than the one I refer to in this text.
The second and third mechanisms generate an “Asymmetric Error-Correction Rules (AECR).”
A Little History on Changing Filing Status Elections
When diving into the historical developments that led to the AECR, we find that from the introduction of joint filing in 1918 and until 1951, a taxpayer’s election of filing status was irrevocable. Meaning that married taxpayers could not change their filing status after the due date for filing the return has passed. However, in 1951, Congress enacted what is currently § 6013(b) [previously § 51(g)]. This provision permits taxpayers—under certain circumstances—to file joint returns after already having filed separate returns for a certain year. As reflected in the legislative history, the reasoning for the change was that “a proper election frequently requires informed tax knowledge not possessed by the average person.” Therefore, disallowing taxpayers to elect the MFJ status and maintain the MFS status “may result in substantially excessive taxes.” Congress did not address possible changes in the other direction, from MFJ back to the default of MFS.
Throughout the years, taxpayers have petitioned the Tax Court after the IRS denied their requests to change their filing status from MFJ to MFS. In Ladden v. Commissioner, 38 TC 530 (1962) as well as other cases, the Tax Court stated that although Congress has explicitly authorized spouses filing separately to change their filing status to filing jointly, such authorization does not mean that it implicitly allows the inverse.
These asymmetric limitations on changing married taxpayers’ filing status generate the aforementioned AECR. On the one hand, those who elected MFS status and later realized it was an inferior election, can correct it to MFJ without incurring a fee and enjoy any associated late benefits. On the other hand, those who elected MFJ status are not afforded the ability to correct the election to MFS status. This AECR is problematic for two main reasons. First, it has an adverse effect on horizontal equity. Similarly situated taxpayers are treated differently based on their ability to correct an election error. Second, it has an adverse effect on the administrability of the tax system. This is because the IRS needs to reallocate resources to process the amended return and it does not impose that cost on the taxpayers.
A Reminder As to Why All of This Matters—And Even More So Today
The U.S. tax system incentivizes married taxpayers to elect the MFJ status by generally offering monetary benefits to those who elect to do so. Such incentives include preferential tax rates and specific tax credits that are not available to married taxpayers filing separately. In addition, there are limitations on itemizing deductions for separate filers, e.g., allowing one spouse to elect to itemize their deductions only if the other spouse also elects to itemize.
Moreover, the U.S. tax system inherently frames the MFJ status as the preferred status for married taxpayers. As a matter of fact, 95% of married taxpayers elect the MFJ status. This means that a disproportionally large number of taxpayers in the U.S. are not able to correct filing status election errors. Because elections are sticky and because many believe MFJ is the only option for married taxpayers, taxpayers are unlikely to revisit a prior election despite a change in their financial circumstances. As a result, taxpayers may be unknowingly locked into an inferior election and are therefore not maximizing their tax benefits.
There are various scenarios in which MFS status is beneficial for a married couple. In general, if both spouses earn similar incomes, the incentive to file a joint return phases-out. A more specific scenario is when a taxpayer has itemized deductions that are dependent upon their adjusted gross income (AGI). For example, consider unreimbursed medical expenses, as defined in IRC § 213. Taxpayers can deduct a larger portion of their medical expenses if their AGI is smaller. Another example is IRC §67(a) miscellaneous itemized deductions, that are currently suspended. These depend on the taxpayer’s AGI, and the size of the benefit increases as AGI decreases.
Taxpayers’ AGI and unreimbursed medical expenses fluctuate over time. This point is especially true for some taxpayers in the current climate. During a pandemic that is coupled with an economic crisis, many married taxpayers are incurring income reductions and increased medical expenses of all sorts. If married taxpayers reelect the MFJ status for tax year 2020 solely because they have traditionally done so in the past, they are potentially creating a larger tax burden for themselves. Even if they realize they have made an election error, they will not be allowed to correct this error after the due date for filing their 2020 tax return has passed.
Another timely example is the recent Economic Impact Payment (EIP) benefit. In filing their 2019 return, low income married taxpayers may be better off maintaining MFS status if one spouse lacks an SSN. This is because the EIP is available to married taxpayers filing jointly only if both have an SSN.
A Solution to the Problem: The Pigouvian All Approach
In my opinion, there are three potential solutions for this overarching problem.
First, an “ALL” approach. To promote fairness, the current § 6013(b) error-correction rule should be expanded, allowing all married taxpayers to change their election from MFS to MFJ and from MFJ to MFS. In both cases, both spouses should agree to making the change. This is in comparison with the current error-correction rule that is available only to a fraction of married taxpayers. This has been the primary argument of taxpayers who have petitioned the Tax Court. Under this approach, however, taxpayers would still not internalize the administrative cost of processing the additional tax return(s). If so, the incentive to think through one’s election ex-ante diminishes. For this reason, this approach is insufficient.
Second, a “NOTHING” approach. This approach would prohibit married taxpayers from correcting a filing status election error from MFS to MFJ and from MFJ to MFS. On the one hand, this would eliminate the asymmetry created by § 6013(b), which as you may remember allows taxpayers in certain situations to switch their status from MFS to MFJ. This solution prioritizes the need for taxpayers to consider the possible ramifications of their filing election choice. On the other hand, this approach is also insufficient because humans make inferior elections and there should be at least some room for error correction.
Therefore, I propose a third approach, which I refer to as “A PIGOUVIAN ALL APPROACH.” This approach acknowledges and promotes both the fairness and administrability principles of tax policy. It is similar to the “ALL” approach, in the sense that the error-correction rule in § 6013(b) will apply to married taxpayers, whether their initial filing status election was MFS or MFJ. In addition, I propose to apply a processing fee that will be deducted from the potential refund the requesting taxpayer(s) is seeking. This way the party who made the error internalizes the administrative costs for correcting it. If the expected refund is lower than the fee, the taxpayer should refrain from correcting the error. In any case, this will increase the salience of the election even if the taxpayer will not correct it this time around.
To conclude, error-correction rules should be consistently applied to all taxpayers. Therefore, it is time to revisit this AECR after almost 70 years since its enactment have passed and the current crisis amplifies the need to do so. In my opinion, applying the existing error-correction rule more broadly combined with a processing fee would reflect better tax policy.