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.
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.