Who Gets the Tax Refund?

Recent Decisions

A review of tax court decisions is instructive. In U.S. v. MacPhail, 313 F.Supp.2d 729 (S.D. Ohio 2003), the parties' 1997 separation agreement provided for a joint tax filing for the previous year but was silent as to payment of any taxes due or entitlement to any refund. The taxes due on the joint return were almost entirely attributable to the wife's income from her family partnership. The wife accompanied the parties' request for an extension to file with a substantial payment from her own funds. When the return was prepared, an overpayment of approximately $300,000 was shown. Instead of requesting a refund, the return indicated that the overpayment was to be credited against estimated tax liability for the following year. The husband filed his separate return first, owing approximately $1000 in taxes. The IRS applied the overpayment to his tax liability and issued him a refund of approximately $299,000. When the wife subsequently filed her return for 1997, claiming the $300,000 credit she thought she had coming, the IRS refused her claim, stating that the husband had already received the refund. Only after protracted negotiation did the IRS acknowledge that the funds had been erroneously paid to the husband and proceeded to give the wife credit on her separate return. Having already spent the money, the husband refused to refund it when the IRS demanded repayment. The IRS then sued both parties. Ultimately, the court determined that the entire credit was appropriately given to the wife because she was the source of the overpayment and the husband, therefore, had no legal right to it.

The moral of the McPhail story is that issues regarding tax refunds, liability, and credits should be resolved between the parties in writing, and that it may be wise to bank the refund rather than hope the IRS will correctly credit it against estimated taxes for a subsequent year.

In U.S. v. Anthony, supra, the wife sought a refund of $125,000, one-half of the $250,000 in estimated tax payments made by the husband for a prior year for which they filed a joint tax return. Because the $250,000 estimated tax payment was made from the income of the husband's sole and separate property rather than from community property, it retained its character as the husband's separate property. The tax court found that the wife never had an ownership interest in the $250,000, and she was, therefore, not entitled to any portion of the refund. The court held that the filing of a joint tax return did not convert the overpayment to community property and did not confer any property interest in the funds to the wife.

In Gens v. United States, 615 F.2d 1335 (3rd Cir. 1980) on remand, 673 F.2d 366 (Ct. Cl. 1982), the wife sought a refund of an overpayment on a joint return that the government had credited to penalties assessed against the husband. Citing Rosen v. United States, 397 F.Supp. 342 (E.D. Pa. 1975), the court observed that it was well settled that spouses filing joint returns retain separate interests in any overpayment, the share of each depending upon the amount contributed to the overpayment, and further noting that the filing of a joint tax return does not create any new property interest of one spouse in the overpayment made by the other. In Gens, the court remanded the case for a determination of the source of the overpayment because it could not discern from the record how much, if any, of the overpayment had been contributed by the wife.

On remand, the evidence revealed that the wife contributed to the income reported on the joint tax return but made no tax payments that resulted in the overpayment. The question before the court was then whether the wife was entitled to a portion of the refund because she contributed to the joint taxable income, even though she did not make any payments toward the tax liability that resulted in an overpayment. Noting that the tax law, IRC '402, directs a refund to the person who made the overpayment and not the person who earned the income, the court held that the wife was not entitled to any portion of the refund.

In Ragan v. Commissioner of Internal Revenue, 135 F.3d 329 (5th Cir. 1998), cert. denied, 525 U.S. 875 (1998), the wife's petition for a portion of the tax refund pursuant to a joint return was denied because she had no ownership interest in the overpayment. Subsequent to filing the joint return, the husband filed for bankruptcy and the entire refund was paid to the bankruptcy trustee. The wife claimed that she was entitled to one-half of the refund and sought payment from the IRS, alleging that the payment of her share of the refund to the bankruptcy trustee was erroneous. Applying Texas community property law, the court held that although personal earnings are community property, they are subject to the sole management and control of the earning spouse, and that filing a joint return does not give one spouse a property interest in the income of the other spouse.

Interestingly, the IRS had sought to require the wife to repay the refund in the event that the court ultimately determined that it had been paid erroneously to the bankruptcy trustee. The court rejected the claim by the IRS and awarded legal expenses to the wife on the basis of the unreasonable position taken by the IRS that amounted to an abuse of power by the government. One cannot count on the court to compensate for governmental overreaching, however, and it should be noted that the IRS frequently issues simultaneous and inconsistent notices of deficiency to both parties on the theory that one of them must be liable. For this reason, it is always advisable for the parties to consult with each other before filing separate returns to insure that their returns are consistent; for example, that the amount deducted for alimony is the same as the amount claimed by the other spouse.

Liability

With regard to liability, in Maragon v. United States, 153 F.Supp. 365 (Ct. Cl. 1957), the court held that the joint and several liability imposed on spouses in connection with a joint return was limited to joint returns and not to the separate liability of one of the spouses on a separate return for another year. The fact that the parties were married did not confer joint and several liability in the absence of an actual joint filing. The court held that the wife was liable only for the tax liability imposed by virtue of her separate filings for the years in question, and the IRS was ordered to refund the wife's overpayment that had been erroneously credited to the husband's tax liability.

The Method for Allocating the Refund

The IRS has developed a formula for determining each spouse's share of a joint tax refund. Rev. Rul. 80-7, 1980-1 C.B. 296. The method set forth in the Estate and Gift Tax Regulations, ' 20.2053-6(f), providing for a formula to determine a decedents' tax liability on their final joint returns was adopted for calculating the spouses' respective shares of an overpayment shown on any joint return.

The Regulations, ' 1.31-1, provide that the recipient of wages from which taxes were withheld is entitled to a credit for the withholding. In community property states in which income earned by either spouse is to be considered community income such that each spouse is considered the recipient of one-half of the total wages, each spouse is entitled to a credit for one-half of the amount withheld. In addition, each spouse is considered responsible for one-half of the total tax liability. For example, a Nevada woman was held liable for half of the tax deficiency assessed against her husband in addition to payment of taxes on her own income. Hardy v. Commissioner, 181 F.3d. 1002 (9th Cir. 1999).

The Regulations, Section 1.6015(b)-1(b), include a method for allocating jointly made estimated tax payments between the parties in the event they file separate tax returns. The formula for allocating the payments is: Separate Tax Liability/Both Separate Tax Liability x Estimated Tax.

This formula also applies in situations where the parties to a joint tax return elect to have their overpayment credited to their estimated tax liability for a subsequent year and then file separate tax returns for that year. Rev. Rul. 76-140, 1976-1 C.B. 376. Revenue Ruling 85-70, 1985-1 C.B. 361 sets forth a method for computing the amount of an overpayment on a joint return that may be credited to one spouse's separate tax liability in a community property state. In cases where the parties have income subject to withholding and also make estimated tax payments, the allocation of any overpayment is determined by the use of both methods.

The formula set forth in Revenue Ruling 80-7 does not apply in community property situations if the source of the overpayment was separate property rather than community income. In states in which community property is subject to the separate debts of either spouse, the government may exercise a right of offset against an amount that would otherwise be refunded to the other spouse for payment of the spouse's separate tax liability. This is true only in states in which community property is subject to the separate debts of either spouse.

The earned income credit is a factor in allocating refunds between spouses to a joint return and the IRS has provided a methodology for determining each spouse's share of any overpayment on returns in which an earned income credit is claimed. Rev. Rul. 87-52, 1987-1 C.B. 347. This formula takes into consideration the fact that, due to the phase-out feature of the earned income credit, a dollar-for-dollar credit calculation cannot be made with respect to the separate liability of each spouse to the joint return. Rather, a calculation of the individual spouse's earned income credit from the joint return is required.

Refunds Under State Law

A tax refund owned by one party pursuant to federal tax law may be marital property subject to distribution under state law, depending upon the timing of the refund. See, e.g., Moore v. Moore, 695 N.E. 2d 1004 (Ind. Ct. App. 1998). The filing of a joint return is not generally seen to be analogous to a financial activity like a deposit into a joint account but serves merely a reporting function. Therefore, the filing of a joint return does not convert the refund from separate property to marital property. See, e.g., Cerny v. Cerny, 656 A.2d 507 (Pa. Super. 1995).

The determination of title under federal tax law does not necessarily end the inquiry as to who gets the refund and how much. Under title-blind equitable distribution statutes, it is the timing of the income that generated the tax liability and overpayment that determines whether the refund is marital property subject to equitable distribution. For example, the Ohio Court of Appeals, Norris v. Norris, Case No. 01 CA 173, (Ohio Ct.App. 2002) 2002 WL 31168063 (Ohio Ct. App. 2002), upheld a trial court decision including a tax refund resulting from a post-divorce separate return of one of the parties in the marital estate for purposes of equitable distribution. Because the income that ultimately generated the refund was earned during the marriage, the court held that the refund was marital property.

Although refunds and liabilities resulting from income earned during the marriage are part of the marital estate for purposes of equitable distribution, penalties and interest resulting from the acts or omissions of one of the parties may be viewed as a separate debt of that spouse. Meints v. Meints, 608 N.W.2d 564 (Neb. 2000).

Issues regarding tax refunds should, where possible, be resolved ahead of time, ideally in writing. A good working knowledge of the applicable tax law will assist the matrimonial practitioner in resolving issues regarding tax returns both before and after the fact.

Income tax refunds can involve substantial sums, and are a frequent source of disputes between divorcing spouses. Before advising a client regarding distribution of a joint tax refund, the matrimonial practitioner should review the applicable law. Federal tax law often dictates a different result from that of state equitable distribution or community property law, and the lawyer must know the difference. Liability for taxes does not necessarily confer a property interest. For example, although the parties to a joint federal income tax return are jointly and severally liable for the taxes payable for the year in question, and although the refund check is drawn to the order of the parties jointly, they do not necessarily have joint ownership rights to the tax refund.

Determining Ownership of the Refund

A refund results from an overpayment of income tax, either by withholding or by estimated tax payments for the year in question. The source of the overpayment determines ownership of the refund. U.S. v. Anthony , No. CIV 97-1772-PHX-SMM, 1999 W.L. 424884 (D. Ariz.1999). Under federal tax law, an overpayment by a married couple is owned by each spouse separately to the extent that he or she contributed to the overpayment. Rev. Rul. 74-611, 1974-2, C.B. 399. Each spouse has a separate interest in the family income as reported on a joint tax return and, consequently, a separate interest in any overpayment. Id.

Recent Decisions

A review of tax court decisions is instructive. In U.S. v. MacPhail , 313 F.Supp.2d 729 (S.D. Ohio 2003), the parties' 1997 separation agreement provided for a joint tax filing for the previous year but was silent as to payment of any taxes due or entitlement to any refund. The taxes due on the joint return were almost entirely attributable to the wife's income from her family partnership. The wife accompanied the parties' request for an extension to file with a substantial payment from her own funds. When the return was prepared, an overpayment of approximately $300,000 was shown. Instead of requesting a refund, the return indicated that the overpayment was to be credited against estimated tax liability for the following year. The husband filed his separate return first, owing approximately $1000 in taxes. The IRS applied the overpayment to his tax liability and issued him a refund of approximately $299,000. When the wife subsequently filed her return for 1997, claiming the $300,000 credit she thought she had coming, the IRS refused her claim, stating that the husband had already received the refund. Only after protracted negotiation did the IRS acknowledge that the funds had been erroneously paid to the husband and proceeded to give the wife credit on her separate return. Having already spent the money, the husband refused to refund it when the IRS demanded repayment. The IRS then sued both parties. Ultimately, the court determined that the entire credit was appropriately given to the wife because she was the source of the overpayment and the husband, therefore, had no legal right to it.

The moral of the McPhail story is that issues regarding tax refunds, liability, and credits should be resolved between the parties in writing, and that it may be wise to bank the refund rather than hope the IRS will correctly credit it against estimated taxes for a subsequent year.

In U.S. v. Anthony, supra, the wife sought a refund of $125,000, one-half of the $250,000 in estimated tax payments made by the husband for a prior year for which they filed a joint tax return. Because the $250,000 estimated tax payment was made from the income of the husband's sole and separate property rather than from community property, it retained its character as the husband's separate property. The tax court found that the wife never had an ownership interest in the $250,000, and she was, therefore, not entitled to any portion of the refund. The court held that the filing of a joint tax return did not convert the overpayment to community property and did not confer any property interest in the funds to the wife.

In Gens v. United States , 615 F.2d 1335 (3rd Cir. 1980) on remand, 673 F.2d 366 (Ct. Cl. 1982), the wife sought a refund of an overpayment on a joint return that the government had credited to penalties assessed against the husband. Citing Rosen v. United States , 397 F.Supp. 342 (E.D. Pa. 1975), the court observed that it was well settled that spouses filing joint returns retain separate interests in any overpayment, the share of each depending upon the amount contributed to the overpayment, and further noting that the filing of a joint tax return does not create any new property interest of one spouse in the overpayment made by the other. In Gens, the court remanded the case for a determination of the source of the overpayment because it could not discern from the record how much, if any, of the overpayment had been contributed by the wife.

On remand, the evidence revealed that the wife contributed to the income reported on the joint tax return but made no tax payments that resulted in the overpayment. The question before the court was then whether the wife was entitled to a portion of the refund because she contributed to the joint taxable income, even though she did not make any payments toward the tax liability that resulted in an overpayment. Noting that the tax law, IRC '402, directs a refund to the person who made the overpayment and not the person who earned the income, the court held that the wife was not entitled to any portion of the refund.

In Ragan v. Commissioner of Internal Revenue , 135 F.3d 329 (5th Cir. 1998), cert. denied, 525 U.S. 875 (1998), the wife's petition for a portion of the tax refund pursuant to a joint return was denied because she had no ownership interest in the overpayment. Subsequent to filing the joint return, the husband filed for bankruptcy and the entire refund was paid to the bankruptcy trustee. The wife claimed that she was entitled to one-half of the refund and sought payment from the IRS, alleging that the payment of her share of the refund to the bankruptcy trustee was erroneous. Applying Texas community property law, the court held that although personal earnings are community property, they are subject to the sole management and control of the earning spouse, and that filing a joint return does not give one spouse a property interest in the income of the other spouse.

Interestingly, the IRS had sought to require the wife to repay the refund in the event that the court ultimately determined that it had been paid erroneously to the bankruptcy trustee. The court rejected the claim by the IRS and awarded legal expenses to the wife on the basis of the unreasonable position taken by the IRS that amounted to an abuse of power by the government. One cannot count on the court to compensate for governmental overreaching, however, and it should be noted that the IRS frequently issues simultaneous and inconsistent notices of deficiency to both parties on the theory that one of them must be liable. For this reason, it is always advisable for the parties to consult with each other before filing separate returns to insure that their returns are consistent; for example, that the amount deducted for alimony is the same as the amount claimed by the other spouse.

Liability

With regard to liability, in Maragon v. United States , 153 F.Supp. 365 (Ct. Cl. 1957), the court held that the joint and several liability imposed on spouses in connection with a joint return was limited to joint returns and not to the separate liability of one of the spouses on a separate return for another year. The fact that the parties were married did not confer joint and several liability in the absence of an actual joint filing. The court held that the wife was liable only for the tax liability imposed by virtue of her separate filings for the years in question, and the IRS was ordered to refund the wife's overpayment that had been erroneously credited to the husband's tax liability.

The Method for Allocating the Refund

The IRS has developed a formula for determining each spouse's share of a joint tax refund. Rev. Rul. 80-7, 1980-1 C.B. 296. The method set forth in the Estate and Gift Tax Regulations, ' 20.2053-6(f), providing for a formula to determine a decedents' tax liability on their final joint returns was adopted for calculating the spouses' respective shares of an overpayment shown on any joint return.

The Regulations, ' 1.31-1, provide that the recipient of wages from which taxes were withheld is entitled to a credit for the withholding. In community property states in which income earned by either spouse is to be considered community income such that each spouse is considered the recipient of one-half of the total wages, each spouse is entitled to a credit for one-half of the amount withheld. In addition, each spouse is considered responsible for one-half of the total tax liability. For example, a Nevada woman was held liable for half of the tax deficiency assessed against her husband in addition to payment of taxes on her own income. Hardy v. Commissioner , 181 F.3d. 1002 (9th Cir. 1999).

The Regulations, Section 1.6015(b)-1(b), include a method for allocating jointly made estimated tax payments between the parties in the event they file separate tax returns. The formula for allocating the payments is: Separate Tax Liability/Both Separate Tax Liability x Estimated Tax.

This formula also applies in situations where the parties to a joint tax return elect to have their overpayment credited to their estimated tax liability for a subsequent year and then file separate tax returns for that year. Rev. Rul. 76-140, 1976-1 C.B. 376. Revenue Ruling 85-70, 1985-1 C.B. 361 sets forth a method for computing the amount of an overpayment on a joint return that may be credited to one spouse's separate tax liability in a community property state. In cases where the parties have income subject to withholding and also make estimated tax payments, the allocation of any overpayment is determined by the use of both methods.

The formula set forth in Revenue Ruling 80-7 does not apply in community property situations if the source of the overpayment was separate property rather than community income. In states in which community property is subject to the separate debts of either spouse, the government may exercise a right of offset against an amount that would otherwise be refunded to the other spouse for payment of the spouse's separate tax liability. This is true only in states in which community property is subject to the separate debts of either spouse.

The earned income credit is a factor in allocating refunds between spouses to a joint return and the IRS has provided a methodology for determining each spouse's share of any overpayment on returns in which an earned income credit is claimed. Rev. Rul. 87-52, 1987-1 C.B. 347. This formula takes into consideration the fact that, due to the phase-out feature of the earned income credit, a dollar-for-dollar credit calculation cannot be made with respect to the separate liability of each spouse to the joint return. Rather, a calculation of the individual spouse's earned income credit from the joint return is required.

Refunds Under State Law

A tax refund owned by one party pursuant to federal tax law may be marital property subject to distribution under state law, depending upon the timing of the refund. See , e.g., Moore v. Moore , 695 N.E. 2d 1004 (Ind. Ct. App. 1998). The filing of a joint return is not generally seen to be analogous to a financial activity like a deposit into a joint account but serves merely a reporting function. Therefore, the filing of a joint return does not convert the refund from separate property to marital property. See, e.g., Cerny v. Cerny , 656 A.2d 507 (Pa. Super. 1995).

The determination of title under federal tax law does not necessarily end the inquiry as to who gets the refund and how much. Under title-blind equitable distribution statutes, it is the timing of the income that generated the tax liability and overpayment that determines whether the refund is marital property subject to equitable distribution. For example, the Ohio Court of Appeals, Norris v. Norris, Case No. 01 CA 173, (Ohio Ct.App. 2002) 2002 WL 31168063 (Ohio Ct. App. 2002), upheld a trial court decision including a tax refund resulting from a post-divorce separate return of one of the parties in the marital estate for purposes of equitable distribution. Because the income that ultimately generated the refund was earned during the marriage, the court held that the refund was marital property.

Although refunds and liabilities resulting from income earned during the marriage are part of the marital estate for purposes of equitable distribution, penalties and interest resulting from the acts or omissions of one of the parties may be viewed as a separate debt of that spouse. Meints v. Meints , 608 N.W.2d 564 (Neb. 2000).

Issues regarding tax refunds should, where possible, be resolved ahead of time, ideally in writing. A good working knowledge of the applicable tax law will assist the matrimonial practitioner in resolving issues regarding tax returns both before and after the fact.