Budget-weary states are increasingly relying on the federal tax intercept program to collect state income tax liabilities. The U.S. Treasury Offset Program (TOP) has long been available to apply taxpayer income tax overpayments to collect nontax debts. Sec. 6402(e) authorizes Treasury to offset a tax refund against the taxpayer’s past due, legally enforceable state income tax obligations. Treasury’s Financial Management Service (FMS) administers the TOP.
Tax preparers need to consider that state tax seizure of federal overpayments will affect the amount of an overpayment available for scheduled federal estimated tax payments. Projected federal tax refunds may not be available for use in payment of the current-year state income tax obligations. New spouses may need to file for injured spouse relief to prevent their share of the refund on a joint return from being applied to their spouse’s separate property state income tax obligation.
An analysis of the requirements placed on states for administration of the program will be helpful when representing taxpayers with state income tax debts. States need to apply for inclusion in the tax intercept program and must adhere to the program’s guidelines. Only state income taxes can be satisfied by the program, and not other types of state taxes.
The California Franchise Tax Board recently issued this note in its online newsletter for tax practitioners:
On June 20, 2011, we will fully participate in the Federal Treasury Offset Program (FTOP), a debt collection program, where we intercept federal refunds for payment of past-due California income tax debts. In a limited study, we collected more than $22 million since September 2008. When fully implemented, we project the number of offsets to dramatically increase.
Before we intercept a federal refund for state income tax debts, we issue a notice to taxpayers by certified mail. The notice allows 60 days for the taxpayer to resolve their debt or expect to have their federal refund intercepted. Taxpayers already in payment plans with us will still be subject to a federal refund intercept until their debt is resolved. [CA Franchise Tax Board, “Treasury Offset Program in Full Swing,” California Tax News (June 2011)]
California currently uses TOP only to collect individual income tax debts. According to its website, California has future plans to use the program to include the interception of corporate income tax overpayments.
There are federal restrictions on which state income tax debts can be collected by the tax offset program. A state may only intercept refunds to pay income tax debts for residents of that state. The state of residency is determined by the address shown on the federal return of the overpayment. The federal overpayment is first reduced by debts with a higher priority with the offset program, such as federal tax payments, child support payments, and federal nontax payments. The state can use the refund offset program to collect an income tax that has been assessed and that has not been delinquent for more than 10 years. States with a longer statute of limitation period for collection will not be able to use the offset program to collect the debt after the first 10-year period.
If a taxpayer has a dispute about the nature of the debt subject to the refund offset, the IRS and FMS will not get involved. Taxpayers can dispute the underlying debt only with the state or federal agency that received the tax refund.
The state is obligated to conform to program rules. It must notify the individual by certified mail that his or her potential refund will be subject to the offset program. The individual will have 60 days to dispute the legality of the assessment or to pay the obligation. The state must actively attempt to collect the tax debt. If the taxpayer has agreed to a state installment payment plan, the state may still use the offset program to collect the tax obligation.
Injured Spouse Rules
The injured spouse rules offer protection to the spouse who is not liable for the state debt. The spouse will need to file Form 8379, Injured Spouse Allocation, with the couple’s current-year joint return to request a refund of his or her share of the joint overpayment. The form instructions direct that the preparer enter the words “Injured Spouse” in the upper left corner of the first page of the joint return. The injured spouse must file this form for each year in which the overpayment is expected to be offset against the other spouse’s debt. The form anticipates that filers may reside in community property states. Form 8379 can also be filed with an amended return, or it can be filed separately.
A spouse may also qualify for an innocent spouse exemption. If the spouse is claiming innocent spouse relief from joint liability, he or she should file Form 8857, Request for Innocent Spouse Relief, instead of Form 8379.
The TOP is used for several different purposes, and the criteria for implementation of each purpose depend on both the federal payment source and the type of debt paid by the offset. Only the federal tax refund is available for payment of outstanding state income tax debts. Other federal overpayments are available for offset against other allowable debts. Other federal sources include Social Security benefit payments, federal salaries, federal civil service retirement benefits, and vendor payments. The type of individual debts that can satisfy the criteria are federal taxes and federal nontax debts such as delinquent federal guaranteed school loans, Small Business Administration loans, and Housing and Urban Development loans. States can use the offset program for past due child support, state income tax debts, and select state unemployment compensation debts.
As government entities face budgetary constraints, the attractiveness of using the TOP to collect other types of state debts may lead to new federal legislation with the aim of increasing state access to federal income tax refunds. The debt collection provisions in the Claims Resolution Act of 2010, P.L. 111-291, signed into law December 8, 2010, are a recent example of the expansion of the TOP. The act authorizes the use of federal income tax refunds to collect erroneous state unemployment benefit payments that were due to delinquent contributions or an individual’s failure to report earnings. Previously, the use of the TOP was limited to excess benefits due to fraud.
The revisions in the Claims Resolution Act also allow the use of the offsets regardless of where the debtor resides. Previously, the unemployment provision offset could be used only if the individual filed the income tax return from the state seeking the offset. In addition, the act eliminates the requirement that the uncollected unemployment compensation debt be unpaid for a maximum of 10 years. The time limit for repayment now defers to the state law provisions concerning when a debt is collectible.
Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, TX. Kristine Wolbach is with McDirmid, Mikkelsen & Secrest, P.S., in Spokane, WA. Prof. Chambers and the author are members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For more information about this column, contact Prof. Chambers at firstname.lastname@example.org.