Chapter 14 Determining the Proper Allocation of Joint Tax Refunds

• Jurisdiction: United States

14. Determining the Proper Allocation of Joint Tax Refunds

Debtor vs. Nondebtor Property of the Estate

Written by:

Nate Hull

Verrill Dana LLP; Portland, Maine

Nicholas M. McGrath

K&L Gates LLP; Boston

Section 541 of the Bankruptcy Code establishes that a debtor's bankruptcy estate includes "all legal or equitable interests of the debtor in property as of the commencement of the case."¹ It is well established that although courts look to federal law to determine whether an interest constitutes property of the estate, it is state law that creates and defines property interests.² In the context of a joint tax return filed by a debtor and nondebtor spouse, each spouse may arguably have a right to claim ownership of some portion of the tax refund. As a result, many bankruptcy courts have dealt with the issue of determining how a joint tax refund should be allocated between a debtor and nondebtor.³ To date, four varying approaches have been used to calculate the appropriate allocation, although some bankruptcy courts are shifting away from the majority "withholding rule" and the popular "50/50 rule" in favor of the more complex "separate filings rule."⁴

A. The Four Rules

The first of the four rules is the majority approach, known as the "withholding rule." This approach divides the joint refund in proportion to each spouse's tax withholdings during the relevant year.⁵ The withholding rule is based on the presumption that a "tax refund is a return of excess payments and thus belongs to the taxpayer who made the payments."⁶ The withholding rule has been criticized as being based on the false assumption that "refunds are the product solely of overpayments" and therefore the rule incorrectly assigns "the nondebtor spouse [with] a portion of the refund proportional to the nondebtor spouse's withholdings and estimated tax payments."⁷ Courts have harangued that the rule paints a "distorted picture" of the refund's origin by ignoring tax credits such as earned income, child tax and education credits.⁸

The second rule is the "income rule," which divides the refund in proportion to each spouse's income during the tax year.⁹ The income rule has not been adopted by many courts, and in fact, since the 1980s the income rule has for the most part been abandoned.¹⁰ Due to its abandonment by many courts, the mechanics of the rule are somewhat unclear. For instance, there is an absence of case law that "clarifies whether the relevant income figure is gross income or taxable income."¹¹ Some courts have noted that under this rule, spouses with equivalent incomes may make disparate contributions to the total tax payment, thereby skewing the allocation.¹²

The third approach is the "50/50 rule," which is "a bright-line rule that is easy to understand and apply."¹³ This approach has gained popularity in recent years because it takes the tax refund and simply divides it equally between the spouses. Courts have stated that the 50/50 rule is based on the principles that (1) marriage is fundamentally viewed as a shared partnership, (2) there is normally an equitable division of marital assets during divorce, (3) there is recognition for contributions made by homemaker spouses and (5) filing a joint tax return renders the spouses jointly and severally liable for the tax.¹⁴ While the 50/50 rule has become an increasingly common approach for bankruptcy courts, some courts have recognized its inapplicability when such an approach is inconsistent with pertinent state laws.¹⁵

The fourth and final approach is the "separate filings rule," which allocates the joint tax refund based on the hypothetical individual tax liability of each spouse had they filed their tax returns as married parties filing separately.¹⁶ According to the separate filings rule, each spouse's contribution to the total payments is determined and then their 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.¹⁷ As such, under the separate filings rule, each spouse is entitled to that portion of the joint refund equal to the amount by which that spouse's contribution exceeds their share of the joint tax liability.¹⁸ In a recent wave of cases, courts have reasoned that the separate filings rule is most in line with the guidance provided by the Internal Revenue Service (IRS) and Internal Revenue Code, and is therefore the appropriate rule to apply.¹⁹ It is this recent trend in which courts have begun to adopt the more complex separate filings rule that this article seeks to address by analyzing the recent decisions of the Massachusetts Supreme Judicial Court (SJC) in Hundley v. Marsh²⁰ and the U.S. Bankruptcy Court for the Eastern District of New York in In the Matter of Duarte.²¹

B. Hundley v. Marsh

The facts of Hundley are straightforward: A debtor and his nondebtor spouse filed joint income tax returns.²² For the 2002 tax year, all of the income reported on the tax return was earned by the debtor and he was the sole source of the payments reflected on the return.²³ Four years later in 2006, the couple filed an amended 2002 tax return in order to carry-back certain business losses of the debtor.²⁴ The carry-back resulted in a $94,910 refund.²⁵ Consistent with the 50/50 rule, the

debtor scheduled a one-half interest in the amended 2002 return.²⁶ The trustee disagreed with a Pavlovian application of the 50/50 rule and instead applied to receive—and was sent—the entire refund.²⁷

Predictably, the nondebtor spouse then initiated an action in the bankruptcy court seeking a determination that she was entitled to half of the 2002 return.²⁸ The court sided with the nondebtor at summary judgment and apportioned the refund 50/50,²⁹ and a direct appeal was taken to the First Circuit.³⁰ Although not requested by the parties to the appeal—recognizing that the "outcome of this adversary proceeding in the bankruptcy court will be wholly determined by the resolution of the dispute over who owns the tax refund under Massachusetts law"—the First Circuit independently certified the following questions to the SJC:³¹

1. Under Massachusetts law, does the tax refund constitute...property of [the debtor] alone or is it property in which [the nondebtor] has a property interest? [; and]
2. If [the nondebtor] has a property interest in the tax refund, what principles

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