On a topic with sparse authority where the lower courts are divided, Bankruptcy Judge Caryl E. Delano of Ft. Myers, Fla., came down on the side of the debtor by holding that Social Security benefits withheld to pay income taxes do not lose their exempt status when refunded by the IRS.

The chapter 7 debtor had some $1,800 a month in Social Security benefits, plus about $400 monthly in other income. After filing, he had a federal income tax refund of $5,500. The debtor claimed $3,700 to be exempt, but the trustee objected, wanting the debtor to turn over the entire refund.

Two federal statutes are in play. The debtor claimed an exemption under 42 U.S.C § 407(a), which says that Social Security benefits

shall not be transferable or assignable, at law or in equity, and none of the moneys paid or payable or rights existing under this subchapter shall be subject to execution, levy, attachment, garnishment, or other legal process, or to the operation of any bankruptcy or insolvency law.

On the other hand, Section 3402(p)(1)(A) of the IRS Code, 26 U.S.C. § 3402(p)(1)(A), allows someone to request that “a Federal payment . . . be subject to withholding under this chapter, then for purposes of this chapter and so much of subtitle F as relates to this chapter, such payment shall be treated as if it were a payment of wages by an employer to an employee.”

The trustee contended that Section 3402 meant that exempt Social Security benefits became the equivalent of wages and lost their exemption when withheld as taxes and later refunded to the debtor-taxpayer.

Bankruptcy courts have ruled both ways on similar objections. A bankruptcy judge in the Eastern District of New York decided in 2017 that the refund was not exempt because Section 3402 meant that the refund was equivalent to the payment of “wages.”

Judge Delano cited a bankruptcy judge in Indiana who had ruled eight years earlier that the protection under Section 407(a) was “exceptionally expansive” and only subject to modification by express statute. In re Spolarich, 2009 WL 10267351, at *4 (Bankr. N.D. Ind. Sept. 30, 2009).

The Indiana judge also said that the characterization as “wages” in Section 3402 was only “for the purposes of” the IRS Code.

Siding with the Indiana decision in her July 20 opinion, Judge Delano reasoned that

social security benefits are protected under 42 U.S.C. § 407 from the claims of the debtor’s general creditors — such as those served by a Chapter 7 trustee — and a debtor’s request that payments be withheld from his social security benefits for his tax debts does not affect the protection from other creditors provided by the statute. [Emphasis in original.]

Judge Delano overruled the objection by the trustee and held that the refund was exempt “to the extent that it is traceable to his social security benefits.”