Injured Spouse - Bankruptcy

[Gretel]

One spouse filed for bankruptcy in 2005 just for himself. Will be discharged next week. Lawyer told them to file form 8379 and bring in tax return after filed and probably they could keep full refund anyway.

1. After discharge of debts IRS will not hold off on refund anyway, right? They only do this while bankruptcy is in progress?

2. If they hold off and we need to file form 8379 how do they deal with the child tax credit?
Injured spouse not entitled to it because it's not his child. Bankruptcy spouse has not enough income to get it. Only the joint return gives them full benefit.

How could I find out about their formulas?

[Koss]

Not Injured Spouse

I think the attorney is making a serious mistake, unless there are back taxes involved in the bankruptcy. Even if this is the case, I don't think injured spouse is the way to go here.

Injured spouse is not applicable unless:

(1) one spouse owes debt that the other spouse is not liable for, AND
(2) it is a type of debt that could be paid by offset of the refund.

Unless they owe back taxes, a pending bankruptcy would actually prevent the IRS from directing the refund to any creditor, because the bankruptcy prohibits that creditor from collecting anything during the bankruptcy proceedings. Bankruptcy freezes all collection processes. The court gets to decide how the debtor's assets get divided up among the creditors. This principle may even apply to back taxes.

Good faith on the part of the debtor is essential in a bankruptcy proceeding. Assuming they owe no back taxes, the idea is that the IRS issues the refund the way normally would, and the debtor turns the refund check over to the bankruptcy trustee so that the funds can be used to pay debt.

Your client's lawyer is probably correct that they will get to keep the entire refund if it is received after the discharge.

But I don't see the point of the injured spouse. They should just wait until the discharge is final, and then file a joint return.

Doing something that is not necessary is probably one of the biggest mistakes we make in taxation. It triggers processes that should not be in effect, and once that happens, it becomes very difficult to stop.

Example: once you file a 941, you'll probably be doing them for the rest of your life, even if you don't have any employees anymore. Once you get into that system, you can't get out.

Unless I am missing some critical piece of information, I think it may be a serious mistake to do an injured spouse claim in the situation you are describing.

Burton

[Gretel]

Thank you so much, Burton. You supported my gut feeling, but I don't have much experience with bankruptcy.

I found out that part of debt is for student loans. We will wait until we know for sure what court is going to do with it before we file the tax return. But if they need to pay back student loan, would you know how IRS deals with the child tax credit and how to learn more about their formulas on the injured spouse form?

[veritas]

There is no discharge for federally guaranteed student loans.

[Koss]

injured spouse formula

I don't know exactly how this is done. But I believe there is an attempt to determine each spouse's individual tax liability, as if they had filed separately. Then they look at withholding, and in this manner determine how much of the joint refund belongs to the injured spouse.

As the previous post noted, student loan debt is generally nondischargeable, but there is a hardship exception. The criteria are extremely difficult to satisfy. Anyone who might actually qualify for hardship discharge of student loan debt should be working with one of top 100 bankruptcy lawyers in the country if they want a reasonable shot at it.

I'm going to assume your client will not be discharged from the student loan debt.

This is going to get really complicated really fast. The scenario you present raises some very interesting questions.

Although student loan debt is generally nondischargeable, a bankruptcy proceeding triggers an automatic stay of any collection proceedings. This means that creditors cannot take any collection action during the pendency of the bankruptcy case. So, for example, if you have a credit card at a bank where you also have a savings account, the account agreements might allow the bank to sieze funds in the savings account if the credit card account is in default. But they can't do this during a bankruptcy case, because the court gets to decide how your assets should be used to pay off your debts. Likewise, if you get behind on your car payments, the right of the lender to reposess the vehicle and sell it at auction to pay off the loan is temporarily suspended during the bankruptcy.

This same principle might apply to the student loan debt. Although it is not dischargeable, the lender may be prohibited from attaching the debtor's tax refund, because the court may want those funds to be used to pay other debt.

Your client should talk with someone at the student loan lender's bankruptcy department, and also call the Treasury Department's Financial Management Service Center. They might be able to get a clear straight answer as to whether the lender and the IRS are even permitted to perform the offset while a bankruptcy is pending.

If your client waits until after the discharge, then this becomes a non-issue. Assuming the student loan debt survives the bankruptcy, then an offset will indeed occur. Filing the return before the discharge might actually be in your client's best interest. The bankruptcy may prevent the offset. The fact that student loan debt is involved is a "critical piece of information" that I did not have when I responded to your original post.

Shifting gears, and assuming that there will be an offset, either because the return is filed after the discharge, or because the offset process is not suspended by the bankruptcy proceeding, I will try to address your original question about the allocation formula for an injured spouse. My theory is probably going to leave you with your mouth hanging open. But if you read the code and the regs, you'll see that I'm right. This has absolutely nothing to do with my controversial interpretation of the new dependent rules for UDC.

In peforming the allocation of income and credits on Form 8379, you are instructed to allocate the child tax credit to the spouse to whom you allocated the dependent exemption. And the instructions are based on the idea that you perform this allocation to reflect what would be done if they were filing separate returns.

In your original post you said that the non-injured spouse can't claim the child tax credit because it's not his kid, and the injured spouse doesn't have enough income to benefit from the credit.

The first part of this assertion is incorrect.

Even if it isn't his child, the spouse who doesn't owe the delinquent student loan can still claim the exemption and child tax credit for the child in question. The child is his stepchild, and this meets the relationship test.

The use of MFS filing status does not change this fact.

It gets even better: Pub. 17 and Form 1040 instructions explicitly say that relationships established by marriage are NOT treated as ending upon death or divorce. So even if this couple gets divorced, the taxpayer can still claim a dependent exemption for the child that was his stepchild when they were married, assuming the other tests are met.

My point is this: if they file separately, the spouse who doesn't owe the student loan can claim the dependent and the child tax credit, and you can indicate this in the allocation section of Form 8379. This will increase the proportion of the refund allocated to that spouse.

With this in mind, perhaps you should examine what would happen if they really filed separately, putting the kid on the non-injured spouse's return.

There is one variable that might destroy this approach: if the spouse who owes the student loan debt is allowed to claim this child because of Form 8332, i.e., the child doesn't actually live with the couple, then I'm not sure the exemption can be put on the other spouse's return. I'm also not sure that it couldn't. Although tax software usually asks, there is nowhere on a joint return filed by mail where you identify who the child "belongs to."

I realize it's a bit of a reach, but an exemption released with Form 8332 could arguably be deemed marital property, at least in a community property state. This argument is strengthened if the Form 8332 has been signed by the noncustodial spouse because the noncustodial spouse is releasing the exemption in order to comply with the terms of the divorce decree. Most of the divorce decree is about dividing up marital property.

No, the kid is not property, but the associated tax benefits might be.

If the child actually lives with the couple, then I am certain that the stepparent can claim the child if they choose to file separately. This particular aspect of the rules has not changed with UDC. Under both the old rules and the new rules, all the dependency tests are met. Stepchild is one of the qualifying relationships.

I've done MFS returns like this, and they've never been challenged. But they weren't really about offsets of debt. It just worked out better for them to file separately because of the bizarre state tax rates here in Ohio.

This is probably going to stimulate some discussion...

Burton

[Gretel]

Burton, thanks a million. Yes, you are right, my mouth is wide open, but more because of your effort you put in to answer my question. Also because I never paid much attention the the "stepchild" relationship. I was focussed too much on the blood relationship. Thank you again for opening my eyes.

In Montana you can file a separate return for married couples on the same form. Sparing us the hassle of having to file a separate 1040 as well.