An interesting question came into the office the other day. The two clients are newly married. One of them has back federal tax issues from joint returns in a previous marriage; the claim of "innocent spouse" was denied and this client's refunds are applied to this back debt. Now that this client has remarried, the other is now an injured spouse and they must file the appropriate paperwork to make sure that the second client's refund is NOT applied to the first's back tax liability. They've already adjusted the first client's federal withholding to be "just right" for that client's share of their current tax liability, so the second client should get most of their federal refund back. There are no back taxes owed to the state.
Of course they can avoid the injured spouse hassle and just file MFS. Alas, there's enough for one to itemize, but not both. They suggest the following strategy for tax year 2008: the first client cranks up their state withholding (to the tune of $400 per month) and thus have sufficient "taxes paid" in 2008 to itemize as well (in about the amount of the standard deduction for MFS) - then they both itemize on MFS returns. Both fully understand that the resulting large state refund will be taxable income the next year. They're willing to do this for as long as it takes (for the former spouse to make good on the debt, to get an OIC accepted, or whatever).
Any problems with this? Do states penalize for substantial overwithholding (the state in question is OK)? Will the IRS see this as an illegal dodge? Inquiring minds want to know...