Generally, when a taxpayer makes an overpayment of tax, the IRS refunds the overpayment to the taxpayer.  But this is not always the case.  For example, the IRS has the statutory authority to credit (or offset) an overpayment against certain other tax debts, including pre-existing federal tax debts.

This offset issue is common with many types of taxpayers:  individuals, corporations, etc.  However, the issue becomes much more common and also confusing with married taxpayers.  This article discusses some of these offset issues in the context of married individuals.

The IRS’s Right of Offset

Section 6402 of the Code authorizes the IRS to credit overpayments to any federal tax liability.  That provision does not provide guidance, though, on what occurs in instances of married taxpayers.  An example illustrates some of the issues that can arise in these circumstances:

The IRS audits Jack’s 2017 tax return.  After the audit, the IRS assesses $100,000 of federal income tax solely against Jack.  The tax debt remains unpaid.  Later, Jack and Jill are married in 2020, and the couple files its first joint income tax return.  On the return, they report a $50,000 refund.

This hypothetical raises the following question:  may the IRS lawfully offset any or all of the couple’s joint income tax refund against Jack’s outstanding 2017 tax liability?  Is it fair to do so even though Jill had nothing to do with Jack’s 2017 tax liability?

The answer to both of these questions may surprise you.  First, the IRS concedes that when married taxpayers file a joint income tax return, each spouse has a separate interest in the jointly reported income—accordingly, each spouse also has a separate interest in the corresponding joint income tax overpayment.  See Rev. Rul. 74-611, 1974-2 C.B. 399.  Second, the IRS also takes the position that it may offset a joint income tax overpayment against the separate tax debt of a liable spouse, regardless of whether the other spouse is liable or not.  See Rev. Rul. 80-7, 1980-1 C.B. 296.

But How Much Can the IRS Offset?

In practice, the IRS routinely offsets the entire joint overpayment against the separate tax liability of a liable spouse, provided there is a sufficient overpayment to do so.  See Rev. Rul. 85-70, 1985-1 C.B. 361.  In these instances, the so-called “injured spouse”—or the spouse that did not have a tax liability—may file a claim with the IRS to have his or her portion of the overpayment refunded.  See Rev. Rul. 84-171, 1984-2 C.B. 310.  The total amount of the refund will depend largely on the state in which the married taxpayers are domiciled.

To file the claim, the injured spouse must file an IRS Form 8379, Injured Spouse Allocation.  Significantly, the IRS Form 8379 may be filed with an original or amended return or even after the return has been filed.  If the injured spouse chooses to make the claim after the filing of a return, the injured spouse should be careful to ensure that the filing of the IRS Form 8379 is timely, i.e., that it is filed within the applicable statute of limitations governing claims for refund.  Moreover, the injured spouse should ensure that he or she properly follows the governing laws of the state in which the married taxpayers are domiciled.  For example, if they reside in a community property state, the injured spouse’s interest in the overpayment, if any, will be governed by the laws of that community property state.  Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

Examples of Overpayments and Offsets in Texas

Rev. Rul. 2004-74.

Various revenue rulings provide guidance to injured spouses on proper allocations and other computations of their share of the overpayment.  For Texas-based taxpayers, that revenue ruling is Rev. Rul. 2004-74.

By way of background, Texas law has rules governing separate and community property.  First, separate property is defined generally as property owned by a spouse prior to marriage or property acquired by a spouse during marriage through gift or inheritance.  Second, community property is defined as any property—other than separate property—acquired by either spouse during marriage.  If the property is community property, each spouse is deemed to have equal 50% interests in the property.  And there is a strong, rebuttable presumption that all property acquired during marriage is community property.

After property is segregated as either separate or community property, community property is broken down further into either sole management property or joint management property.  Sole management property is generally defined as the personal earnings of a spouse (e.g., wages); revenue from separate property; and any increase in value or revenue from all property subject to a spouse’s sole management, control, and disposition.  Conversely, joint management property is defined as property that is not sole management property and that is not subject to an agreement amongst the spouses.

Creditor Rights under Texas Law

Texas law further defines the rights of creditors vis-à-vis separate property, sole management property, and joint management property.  Those rules are summarized below:

  • Separate Property. Creditors may reach the separate property of a liable spouse but may not reach the separate property of a non-liable spouse.
  • Sole Management Community Property. Creditors may reach all of the community property subject to the liable spouse’s sole management, control, and disposition to satisfy that spouse’s separate liability.  Creditors may not reach any portion of the community property subject to the non-liable spouse’s sole management, control, and disposition.
  • Joint Management Community Property. Creditors may reach all community property subject to the spouse’s joint management, control, and disposition, whether the debt was incurred before or during marriage.
  • The Fifth Circuit’s Decision in Medaris. In Medaris, the Fifth Circuit held that the IRS may reach the liable spouse’s 50% interest in the non-liable spouse’s sole management community property to satisfy a separate federal tax liability of the liable spouse.  See Medaris v. U.S., 884 F.2d 832 (5th Cir. 1989).

The Five Steps

With the above law in mind, the IRS applies five steps to determine the amount of the overpayment that may be offset against any existing federal tax debts of a spouse.  These steps are:

Step 1:  Identify the underlying source of the overpayment.  In this step, the IRS looks to the tax payments made by the spouses, including income tax withholding and estimated tax payments and other credits.

Step 2:  In the second step, the IRS characterizes the source of the overpayment as either separate or community property.  Generally, an overpayment is characterized in the same manner as the source of the overpayment.  Thus, an overpayment may be characterized as community property, separate property, or partly community and partly separate, depending on the character of the source of the overpayment.

Step 3:  The third step involves offsetting the liable spouse’s share of the overpayment from a community property source against the liable spouse’s separate tax liability.  As indicated above, the IRS may offset the liable spouse’s 50% interest in the overpayment from a community property source to satisfy the liable spouse’s separate tax liability.  See Rev. Rul. 85-70.

Step 4:  In the fourth step, the IRS determines whether, under state law, the IRS may reach any other portion of the overpayment from a community property source.

Step 5:  The last step is to determine whether the IRS may, under state law, reach any portion of the overpayment from a separate property source of the liable spouse or the non-liable spouse.

Application of the Five Steps and Texas Law.   

The following two examples illustrate the five steps and their application to Texas law.

Example 1.  In 2020, Anne, who is single, incurs a federal tax debt of $20,000.  Anne does not pay the tax.  In 2021, Anne and Tom marry.  In 2024, Anne and Tom file a joint income tax return for their 2023 tax year, claiming an overpayment of $1,000.  The overpayment resulted from income taxes withheld from Anne and Tom’s wages in 2023.

For these purposes, assume that $750 of the overpayment is attributable to community property subject to Anne’s sole management community property.  Assume further that $250 of the overpayment is attributable to Tom’s sole management community property.

Analysis:

Step 1.  The source of the overpayment is from income taxes withheld in 2023 from the wages of Anne and Tom.

Step 2.  As indicated above, Texas law presumes that all property acquired during marriage by either or both spouses is community property.  This includes wage income.  Because Texas law presumes that wage income is community property, the entire overpayment is assumed to be from a community property source.

Step 3.  Under Medaris, the IRS may offset $375 of the income tax withholding attributable to Anne’s wages and $125 of the income tax withholding attributable to Tom’s wages.  Accordingly, the IRS may offset $500 of the overpayment against Anne’s 2020 tax debt.

Step 4.  Under Texas law, the IRS may also reach all community property subject to a liable spouse’s sole management, control, and disposition, and all community property subject to both spouse’s joint management, control, and disposition.  Thus, in addition to the $500 offset in Step 3, the IRS may also offset the remaining $375 of the $750 overpayment that is attributable to community property subject to Anne’s sole management, control, and disposition.  Because there is no separate property, Step 5 does not apply.  Accordingly, the IRS may offset $875 ($500 + $375) of the $1,000 overpayment against Anne’s separate tax liability.

Example 2.  Assume the same facts in Example 1, except that the entire overpayment resulted solely from income tax withholding from Tom’s wages, and the entire overpayment is attributable to community property subject to Tom’s sole management, control, and disposition.

Step 1.  The source of the overpayment is from income taxes withheld in 2023 from the wages of Anne and Tom.

Step 2.  As indicated above, Texas law presumes that all property acquired during marriage by either or both spouses is community property.  This includes wage income.  Because Texas law presumes that wage income is community property, the entire overpayment is assumed to be from a community property source.

Step 3.  Under Medaris, the IRS may offset $500 of the income tax withholding attributable to Tom’s wages.  Accordingly, the IRS may offset $500 of the overpayment against Anne’s 2020 tax debt.

Step 4.  Under Texas law, the IRS may not reach the sole management community property of a non-liable spouse.  Accordingly, the IRS may not offset any additional amounts in Example 2.  It may only offset $500 of the overpayment against Anne’s 2020 tax debts.

Conclusion

Combining finances is never easy—particularly if one spouse brings significant pre-existing federal tax debts to a marriage.  If the IRS offsets a joint income tax refund, an injured spouse may file an IRS Form 8379 to try to claw back his or her share of the overpayment.  Alternatively, taxpayers wishing to get married may consider other alternatives, such as a pre-marital agreement.  Because the right alternative to utilize will depend largely on the unique facts and circumstances of the married taxpayers, married taxpayers may consider discussing their tax problems with a tax professional prior to walking down the aisle.

 

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