It’s almost springtime, and thoughts in the bankruptcy world naturally turn to … tax refunds. To be sure, bankruptcy trustees have been busy for the last six months ensuring that debtors will turn over their pre-petition tax refunds. Debtors’ counsel have been equally busy advising their new clients on how to protect their tax refunds in advance of filing. As the tax filing deadline approaches, now is a good time to review the status of tax refunds in bankruptcy cases.
First, let’s look at the easy stuff. In a typical chapter 7 case, the right to an income tax refund based on pre-petition income is property of the estate. The tax refund is considered property under § 541(a) and is not considered income.[1] The portion that arises from pre-petition income is property of the estate, while the portion that arises from post-petition income is property of the debtor and may be claimed exempt.[2] While there are multiple ways to allocate the distribution of a tax refund between the debtor and the estate, it is generally distributed, pro rata, by days.
The refund is divided over a 365-day year and then multiplied by the number of days from the beginning of the year to the petition date. For example, for the 2015 tax year, a debtor will receive a $5,000 refund. The debtor filed for chapter 7 protection on Aug. 1, 2015. The bankruptcy estate would be entitled to 213/365 x $5,000, or $2,917, based on the pro rata allocation method.
Tax credits including the earned income credit, the child tax credit and net operating losses are also property of the estate. While property of the estate may be claimed exempt, in Nevada, for example, under the wild card exemption, NRS 21.090(1)(z), the claim of exemption would not protect the debtor’s refund against the right of the IRS to set off a refund against prior tax liability.[3] Further, the community property portion of the tax refund is considered property of the estate under § 541(a)(2).[4]
Future tax refunds, based on disposable income, generally become property of a chapter 13 bankruptcy estate for the 36- to 60-month duration of the plan. However, if the case is converted to a chapter 7 proceeding, under § 348(f) property of the estate consists only of property of the estate on the petition date, less amounts lawfully removed by the debtor.[5] In a recent Ninth Circuit BAP case, the court applied the same reasoning in an individual chapter 11 case.[6]
In In re Markosian,[7] the Ninth Circuit BAP applied the reasoning behind § 348(f) to a conversion of a chapter 11 proceeding to a chapter 7 proceeding. Under § 1115, a BAPCPA amendment, property of a chapter 11 estate includes all property the debtor acquired after commencement of the case. But chapter 11 does not include a statutory counterpart to § 348(f). The court concluded, however, that when a chapter 11 case is converted to a chapter 7 case, the property of the chapter 7 estate is determined as of the date of filing and thus does not include post-petition earnings or tax refunds.
Most financial planners will tell you that a large tax refund probably means that you over-withheld the tax on your income. Debtors need to consider that advice, along with the legal status of a tax refund in a bankruptcy case, long before they file for bankruptcy relief. So while spring is as good a time as any to review the impact of a bankruptcy filing on a debtor’s tax refund, it should be a year-around consideration.
[1] Kokoszka v. Belford, 417 U.S. 642 (1974).
[2] See, generally, In re Feiler, 218 F.3d 948 (9th Cir. 2000).
[3] See United States v. Gould (In re Gould), 401 B.R. 415, 428 (B.A.P. 9th Cir. 2009).
[4] See In re Martell, 349 B.R. 233 (D. Idaho 2005).
[5] In re Salazar, 465 B.R. 1247 (B.A.P. 9th Cir. 2012).
[6] In re Markosian, 506 B.R. 173 (B.A.P. 9th Cir. 2014).
[7] In re Markosian, 506 B.R. 173 (2014).