Court Holds that Overpaid Taxes Cannot be Turned Over to the Estate Under Section 542(a)

Tax refunds and the election by consumer debtors to apply those refunds to future tax liability can raise many issues in consumer chapter 7 and chapter 13 bankruptcies. One issue is whether the debtor is entitled to the refund from the election or whether the refund is property of the estate that can be used to satisfy the debtor’s prepetition obligations. Section 541 [1] of the Bankruptcy Code, defining property of the estate, should directly address these issues, but courts addressing the issue have resolved it in different ways.
            
In Weinman v. Graves (In re Graves) [2], the Tenth Circuit added to the uncertainty. The court rejected the view held by the Ninth Circuit that refunds from irrevocable tax elections could be turned over to the estate as property of the estate under section 542 [3] of the Bankruptcy Code. Rather, the court held that the trustee did not have the power to force turnover of the irrevocable tax elections. [4] The trustee was barred from recovering any portion of the refund from the election before the refund vested back to the debtor. [5] Furthermore, the only portion of the refund the trustee was entitled to recover was the portion that was attributable to prepetition earnings. [6]
            
Part I of this note discusses the ruling of the Tenth Circuit in Weinman v. Graves and its effect on consumer tax elections. Part II discusses and compares the Ninth Circuit’s approach to the Tenth Circuit’s approach to handling irrevocable tax refunds. Part III discusses what effect these rulings may have outside of the context of consumer tax elections, examining the issue in light of commercial scenarios. The note concludes that the rulings of the Ninth Circuit on irrevocable tax elections create uncertainty for the debtor, but the ruling of the Tenth Circuit in Graves can be used as a bankruptcy planning tool for the debtor in both chapter 7 and 13 cases.

Background and Ruling in Weinman v. Graves
In Weinman v. Graves (In re Graves) [7], the Tenth Circuit held that § 542(a) [8] does not permit a chapter 7 trustee to force the IRS to turn over overpaid taxes of joint debtors where the debtors elected to apply the overpayment to the next year’s tax liability. In Graves, the joint debtors elected to apply their 2006 tax refund to their 2007 tax liability.[9] Two months after filing their tax returns, the debtors filed for bankruptcy. [10] The bankruptcy court denied the trustee’s motion to order the IRS to turn over the debtors’ 2006 tax refund under § 542(a).[11] The Bankruptcy Appellate Panel (BAP) [12] and the Tenth Circuit affirmed the bankruptcy court’s ruling. [13]

The Tenth Circuit held that the trustee could not force the IRS to turn over the tax refund at the time the motion was filed. [14] Instead, the trustee was entitled to only the portion of the refund that was attributable to prepetition earnings that remained after the refund had been applied to the following year’s tax liability. [15] For example, if a debtor elected to apply his or her tax refund to the next year’s tax liability on April 15, 2011, and filed for bankruptcy on April 16, 2011, then once the refund was applied to the 2012 tax liability on April 15, 2012, the trustee would only be able to recover any remaining refund that was attributable to income earned by the debtor before April 15, 2011.

The Tenth Circuit stressed the irrevocable nature of the refund. [16] The court reasoned that the debtors’ election to apply the refund to future tax liability was irrevocable under § 6513(d) of the Internal Revenue Code (IRC). [17] Section 6513(d) provides that an “overpayment of income tax…claimed as a credit against estimated tax for the succeeding taxable year…shall be considered as a payment of the income tax for the succeeding taxable year…and no claim for credit or refund of such overpayment shall be allowed for the taxable year in which the overpayment arises.” [18] 

Based on § 6513(d) of the IRC, the debtors’ interest in the refund was limited to the remainder of the refund, if any, after it was applied to the debtors’ 2007 tax liability. [19] The estate, therefore, would only have an interest in that portion of the refund that had been applied to the debtor’s 2007 tax liability, because the estate can take no greater interest in the property than the debtors’ interest at commencement of the case. [20]  Moreover, the court further narrowed the property of the estate to only those portions of the refund that were attributable to prepetition earnings. [21]

Rulings in the Ninth Circuit
Not all jurisdictions, however, accept the rationale applied by the Tenth Circuit in Graves. In two separate cases, the Ninth Circuit rejected the analysis used by the Tenth Circuit and viewed irrevocable tax elections as property of the estate before the refund is returned to the debtor. 

In Nichols v. Birdsell (In re Nichols), [22] a case with facts similar to Graves, the Ninth Circuit held that the trustee could force the IRS to turn over the current refund of a debtor’s overpaid taxes. [23]  Rather than focus on the irrevocable nature of the refund, as was the focus of the court in Graves, the Ninth Circuit focused on the expansive definition of “property” under § 541(a) to reach its conclusion. [24] The court also dismissed the argument that the irrevocable nature of the election precluded the refund’s inclusion in the estate as irrelevant. [25] Finally, the court cited as dispositive one of its prior decisions, In re Feiller. 26]

In Feiller, the Ninth Circuit applied reasoning similar to the court in Nichols, but in the context of an avoidance action, not a turnover action. In Feiller, the co-debtors made an election to carry forward net operating losses (NOL) [27] under § 172(b) [28] of the Internal Revenue Code.[29] Five months after making the election, the co-debtors filed for bankruptcy relief under chapter 7. [30] The Ninth Circuit ruled that the NOL could be avoided by the trustee under § 548(a)(1) [31] of the Bankruptcy Code.

In Feiller,the Ninth Circuit dismissed the argument that the irrevocability of the election to carry forward the NOL precluded the NOL from being property of the estate. [32] An NOL is the excess of operating losses over revenue, the amount of which can be deducted from gross income for tax purposes. [33] Under § 172(b)(3) of the Internal Revenue Code, the debtor can elect to carry forward NOLs. [34] Like the refund election in Graves, the election to carry forward an NOL is irrevocable. [35] In determining that the NOL was property of the estate, the court in Feiller cited to the broad definition of property of the estate under § 541 of the Code and disregarded the irrevocable nature of the NOL. [36]

To support its decision, the court also cited to a Supreme Court opinion that held that NOLs were part of the bankruptcy estate. [37] In Segal v. Rochelle, the Supreme Court held that refunds from a carry-back of an NOL were considered property of the estate. [38] In Segal, the Court acknowledged that the debtor did not have any interest in the refund at the present time, [39] but noted that the right of the debtor to the refund at the end of the taxable year constituted property of the estate. [40]

The Ninth Circuit then decided, regardless of whether Segal created a property interest for the estate in the NOL, that the act of carrying forward the NOLs [41] was an accounting mechanism to determine when the debtors would be entitled to the refund. [42] Therefore, the debtors in Feillers retained a property interest in the refund and were merely out of possession of the refund at the commencement of the case. The fact that the refund was carried forward was irrelevant. [43] The court reasoned that the debtors’ ability to choose to apply the refund to future years by carrying the NOL refund forward showed that the debtor had an interest in the refund. [44]  The debtor’s interest in the refund thus became property of the estate upon commencement of the case, and the action to avoid the carry forward of the NOL as a fraudulent transfer was allowed under § 548 of the Bankruptcy Code. [45]

Effects of the Ninth and Tenth Circuit’s Rulings
The differing holdings of the Ninth and Tenth Circuits impact issues beyond a chapter 7 consumer bankruptcy. The rulings of these two circuits may affect how other forms of irrevocable tax elections are treated in bankruptcy, as well as how disposable income for a consumer debtor’s chapter 13 case is calculated.

A. Effects of the Tenth Circuit’s Ruling in Weinman v. Graves
Based on the Tenth Circuit’s emphasis on irrevocability in Graves, the Tenth Circuit would likely be required to hold that other irrevocable tax elections, such as the election to carry forward NOLs, are not property of the estate. Because the NOL would not be property of the estate, the trustee would not be able to force the turnover of the NOL. In contradiction to this result, the Supreme Court in Segal [46] held that NOLs were property of the estate. Segal dealt with an NOL applied to previous years, however, and the Court’s ruling in that case may not be applicable to NOLs that have been carried forward.

The Tenth Circuit’s ruling in Graves may also lead the court to rule that an irrevocable tax election refund cannot be avoided as a fraudulent transfer under § 548 [47] or as a preference under § 547. [48] The fact that the court does not believe the refund is property of the estate indicates that the estate does not have a right to the property and thus would not be eligible to become part of the estate through an avoidance action. However, because an avoidance action brings assets back into the estate that the debtor did not have an interest in at the commencement of the case, the Tenth Circuit’s determination in Graves that the refund was not property of the estate may be irrelevant in an avoidance action. Therefore, even though the Tenth Circuit ruled that a refund could not be turned over, an avoidance action may bring the refund back into the estate.

A trustee attempting to bring an irrevocable tax refund back into the estate may also want to argue that the refund is property of the estate because the debtor must affirmatively elect to apply the refund to future tax liability. [49] Although Feiller was a Ninth Circuit case, the court in that case held that the NOL was property of the estate because the debtor’s affirmative act of electing to carry forward the NOL showed that the debtor had an interest in the property. [50] A similar argument could be used for avoiding the application of the refund to future tax liability as a fraudulent transfer. The election to apply the refund to future tax liabilities is an affirmative action just as the election to carry-forward the NOL was in Feiller.

The election to apply the refund to later tax liability is also an accounting mechanism, as was the carrying forward of the NOL in Feiller. Regardless of whether the refund is applied to the current tax liability or future liabilities, the debtor is entitled to the refund at some point in time. Thus, the debtor has a non-possessory interest in the refund that can become property of the estate under § 541 of the Bankruptcy Code. [51]

In addition, by ruling that the irrevocability of an overpayment on taxes bars turnover of a refund, the Tenth Circuit has enabled debtors to shield some of their assets from the bankruptcy estate. Debtors may now be more inclined to elect to apply the overpayment to future tax liabilities before filing for bankruptcy in an attempt to use what would be pre-petition assets to satisfy post-petition obligations. Applying the refund to future tax liability reduces the pool of assets that creditors would normally be able to reach, absent the refund-application election, and decreases the payout to creditors.

Finally, the Tenth Circuit’s ruling could also have implications on determining disposable income for a chapter 13 case. Under § 1325(b)(2) of the Bankruptcy Code, the amount of each payment made by the debtor to creditors under the chapter 13 plan is determined by calculating the debtor’s disposable income, [52] which is the difference between the debtor’s current monthly income and all reasonable and necessary expenses. [53] Current monthly income is calculated by taking the “average monthly income from all sources that the debtor receives” over the sixth-month period prior to filing the petition for bankruptcy relief.[54] This allows the debtor to overpay his taxes prior to the filing of the petition, elect to apply the refund to later tax liability, and decrease current monthly income for purposes the chapter 13 case. The end result of these actions is that the debtor pays less per month to creditors than if the debtor had elected to take the refund in the year it was attributable. Absent the refund-application election, the entire refund would have been included in the calculation of the debtor’s income for the previous six months, and would have increased the amount of the debtor’s disposable income, thus increasing the amount paid each month to creditors. [55]

With the Tenth Circuit’s decision in Graves, the court has effectively given debtors an additional tool for bankruptcy planning. The debtor can shield pre-petition assets from creditors by overpaying their taxes and having pre-petition earnings applied to post-petition tax obligations. The debtor can also decrease his current monthly income by overpaying his or her taxes and electing to apply the refund to future tax liabilities.

B. Effects of the Ninth Circuit’s Rulings in Feiler and Nichols
By ruling that an irrevocable tax election is part of the estate, the Ninth Circuit added another level of uncertainty to the debtor’s post-petition affairs. Every time a debtor makes a tax-refund election, he will be unsure whether or not that refund is property of the estate. This can affect how the debtor plans his or her post-petition affairs, how the debtor calculates his or her monthly budgets in order to avoid insolvency again, and the debtor’s pre-petition affairs in determining what the debtor must give up to the estate. 
            
Some of the reasoning used by the Ninth Circuit in its Feiller opinion for determining that the NOL is property of the estate is also susceptible to criticism. The court cites the Supreme Court decision of Segal v. Rochellefor the proposition that an NOL is property of the estate. [56] However, Segal is a Bankruptcy Act case, decided 12 years before Congress passed the Bankruptcy Code. [57] More importantly, in Segal, the NOL in question was not an NOL that had been carried forward; [58] the NOL was applied to past years, as is the default rule for an NOL [59] under § 172 of the Internal Revenue Code. [60] The debtor was also not entitled to the refund until the end of the taxable year, after the debtor had filed for bankruptcy. [61] Thus, in Segal the refund was attributed to pre-petition losses. In Feiller, the NOL was attributable to post-petition years, as the debtor elected to carry the NOL forward. It is a general principle that post-petition earnings and assets in a chapter 7 case are not property of the estate. [62]

Finally, in Segal, the Supreme Court specifically stated that it was leaving open the question as to whether a carried forward election is property of the estate. [63]  Moreover, the Court hinted that it was skeptical about whether an NOL that had been carried forward could even be property of the estate. [64] For all of the foregoing reasons, the Ninth Circuit’s reliance on Segal may be misplaced.

Conclusion
In Weinman v. Graves, the Tenth Circuit ruled that the refund from an irrevocable tax election was not property of the estate and could not be turned over to the estate. This ruling conflicts with two cases in the Ninth Circuit holding that irrevocable tax elections could be both turned over to the estate and avoided as a preference and fraudulent transfer. Both rulings create advantages and disadvantages for debtors. The Ninth Circuit’s rulings create uncertainty for debtors as to what is and is not property of the estate and may place too much reliance on an inapposite precedent. The Tenth Circuit's ruling, on the other hand, provides greater certainty as to the bounds of the bankruptcy estate. The benefits of that certainty, however, may be mitigated by the policy implications: The ruling can effectively be used as a bankruptcy planning tool to shield assets from creditors in a chapter 7 case and to decrease the amount paid to creditors every month in a chapter 13 case.