Assume that all of an individual’s income is from pensions and retirement accounts that themselves are exempt. What if the chapter 7 debtor pays too much withholding and is entitled to tax refunds? Are the tax refunds exempt or not?
Bankruptcy Judge Laura S. Taylor of San Diego said the result turns on whether “the applicable state law provides for tracing of exempt funds.”
In her Sept. 1 opinion, Judge Taylor found five decisions around the country on the issue. When the income itself was exempt, three held that tax refunds are likewise exempt, but two found no exemption for refunds. Those cases, she said, all turned on whether state law allows tracing.
To resolve the case at bar, Judge Taylor relied on Section 703.080 of the California Code of Civil Procedure, entitled “Tracing of Exempt Funds,” which provides that “a fund that is exempt remains exempt to the extent that it can be traced into deposit accounts or in the form of cash or its equivalent.”
Ruling that the refunds were exempt, Judge Taylor held that “the exempt nature of [the debtor’s] retirement distributions survived the trip through the IRS . . . where, as is the case here, all her income was exempt.”