Protecting the Child Tax Credit and Additional Child Tax Credit in Bankruptcy

The Child Tax Credit statute (CTC), codified in 26 U.S.C. § 24, has received varying degrees of protection in bankruptcy proceedings. Consumer debtors receiving a tax refund attributable to the statute must decide how to treat tax refund proceeds early on in their bankruptcy proceeding. Two emergent trends from bankruptcy courts around the country demonstrate that consumers may either (1) try to exclude the proceeds as nonestate property, free from the claims of creditors; or (2) acknowledge the proceeds as property of the estate protected by use of an appropriate exemption.

Understanding the Benefits

The CTC provides tax relief to taxpayers who receive earned income with at least one “qualifying child.” However, the statute restricts the meaning of “qualifying child” to a person “who has not attained the age of 17.”

The CTC establishes two distinctive taxpayer benefits. First, the CTC is a nonrefundable credit that can reduce an individual’s tax liability to 0.[1] This would be considered an intangible benefit that may not necessarily become an asset of the estate. In some circumstances, however, the nonrefundable credit can generate a refund when another separate tax benefit is stacked on top of the CTC. This second benefit available to taxpayers includes a tangible refund for lower-income families. Known as the Additional Child Tax Credit (ACTC), which was enacted by Congress, this benefit entitles eligible taxpayers to a direct refund of a portion of their CTC. The ACTC “is not actually an additional credit on top of the CTC.”[2] Because the ACTC is refundable, the ACTC may result in taxpayer overpayment, and ultimately a refund.

Child Tax Credit and the Bankruptcy Estate

Whether consumer debtors should seek to exclude this benefit as nonestate property or move to exempt its value is often determined by the state in which the case is filed. Consumers should consider the nature and extent of their interest in any potential refund or tax credit when preparing their case. Is the benefit in existence at the time of filing, or does the debtor have a future contingent interest in the benefit, the value of which could come within the purview of the estate? Pursuant to 11 U.S.C. § 541(a)(1), the estate is comprised of all property that the debtor holds a legal or equitable interest in, wherever located and by whomever held, as of the commencement of the case. In order for a tax refund to be considered property of the estate, the refund must be “‘sufficiently rooted’ in the debtor’s pre-bankruptcy past,” although there is no judicial consensus on that exact standard.^[3]

There is also no judicial consensus on whether CTC may be categorically excluded as property of the estate. Even among courts agreeing that there is no categorical exclusion of this asset, there is a conflict of authority on the question of how to apportion and treat a debtor’s pre-petition and post-petition interest in CTC.

Categorical Rules

The distinction between nonrefundable CTC and refundable ACTC has generated conflicting positions by the courts as to whether CTC may be categorically excluded from the bankruptcy estate. One position treats only the refundable ACTC component as property of the estate. Courts following this approach exclude the nonrefundable component from the bankruptcy estate because only refunds constitute property of the estate.^[4] Nonrefundable credits do not count as “payments” that fall within the bankruptcy estate.^[5]

The U.S. Bankruptcy Court for the Western District of Missouri adopted this position in a chapter 7 proceeding, In re Law. The debtor treated a $2,000 portion of their federal tax refund derived from both CTC (in the amount of $69) and ACTC (in the amount of $1,931) as a unitary credit.[6] The debtor claimed that the supposed unitary tax credit fell outside the bankruptcy estate.[7] The chapter 7 trustee objected, contending that the bankruptcy estate encompassed the entire $2,000.[8] The bankruptcy court followed “the tradition of Solomon” to “split the proverbial and literal child (tax credit).”[9] The court considered the refundable ACTC in the amount of $1,931 to be property of the estate, but not the remaining $69.[10] In making this split, the court relied on the Supreme Court case of Sorenson v. Secretary of the Treasury of the United States.[11] Although not a bankruptcy case, Sorenson equated the refundability of the federal earned income tax credit with an “overpayment of tax.”[12] The court in In re Law concluded with the following syllogism:

1. Under Sorenson, tax refunds are tax overpayments.[13]
2. Tax overpayments are property of the estate.[14]
3. Tax refunds like the ACTC are property of the estate.[15]

On Jan. 26, 2006, the Eighth Circuit BAP affirmed the bankruptcy court’s decision in In re Law, but rejected the applicability of Sorenson on the basis that Sorenson was not a bankruptcy case.[16] Nevertheless, the U.S. Bankruptcy Court for the Northern District of Ohio quoted the Missouri bankruptcy court’s application of Sorenson with approval in discussing possible exemptions in the case of In re Parker.[17] Some courts continue to recognize “the refundable portion of the credit” as property of the estate.[18] However, the nonrefundable portion itself merely cancels out tax debt; it does not independently create an asset. An asset only results when there is some other tax benefit involved. To protect tax refund proceeds attributable to the nonrefundable CTC, the debtor must first reduce their tax liability with CTC, then claim some other tax benefit under an exemption.[19]

Other courts have ruled that the bankruptcy estate encompasses both the CTC and ACTC. In these cases, courts have found that the refundable portion of a debtor’s CTC becomes property of the estate and cannot be excluded.^[20] This position forces a debtor to prioritize their available exemptions in order to protect their refund, or risk losing it to their trustee in a potential turnover action.

A debtor in a chapter 7 proceeding before the U.S. Bankruptcy Court for the Eastern District of New York experienced this misfortune in In re Parisi. The debtor in Parisi argued that Congress intended for Child Tax Credit Statute proceeds to be a grant held by the debtor in trust for the benefit of her children. The debtor argued that she was merely a conduit for her children, but did not distinguish between the CTC and ACTC. The chapter 7 trustee prevailed in a turnover action to receive all child tax credit proceeds, regardless of whether they were attributable to CTC or ACTC. The court refused to characterize ACTC and CTC proceeds as funds held in trust. With respect to the nonrefundable CTC, the court determined that the debtor could not use CTC to both (1) reduce tax liability and (2) shield tax refund proceeds from the bankruptcy estate. With respect to the ACTC, the court ruled that even though the debtor’s refundable entitlement to ACTC would not be “finalized” until the end of the tax year, the debtor’s interest in ACTC is “sufficiently rooted” in her pre-petition past.

It is true that both positions of the courts appear to disfavor a debtor’s ability to protect their interest in their tax credit or refund. Like a cash asset, the value of these benefits will be made available for creditors if not excluded or properly exempted. It should be noted, however, that in the face of a challenge to a debtor’s exclusion or exemption of this asset, the debtor may still rebut this presumption to maximize their protected benefits. This argument may be raised depending on how the courts in the debtor’s district and circuit have ruled with respect to the pre- and post-petition allocation of the CTC proceeds.

Understanding Allocation

The timing of a consumer debtor’s earned income and the number of qualifying children determine which of two allocation methods a consumer debtor should use. Some courts prorate the pre-petition portion of the refundable component on a day-to-day basis.^[21] In the context of tax withholdings, this approach focuses on the “mathematical relationship between the days withheld before and after the petition is filed.”^[22]

Other courts examine “each of the components of the tax refund to determine whether, on the petition date, the debtor possessed a legal or equitable interest in that component.”^[23] For calculating pre-petition interest in ACTC, this approach requires considering the number of qualifying children before the petition date, and the amount of pre-petition earned income.^[24] Debtors attempting to apply the components-based method bear the burden of showing that “neither income nor credits” accumulate “with regularity through the tax year.”^[25]

The component-focused method of allocation provided a benefit for the debtor in In re Donnell, a chapter 7 proceeding before the U.S. Bankruptcy Court for the Western District of Texas. In Donnell, the debtor’s only pre-petition income consisted of unemployment benefits. Unemployment benefits do not qualify as “earned income” and therefore do not give rise to an interest in ACTC.[26] Because the debtor could not have qualified for ACTC during the pre-petition portion of the tax year, her interest in ACTC was entirely post-petition.

But what if the debtor drew a salary pre-petition and lost her job the day after filing the bankruptcy petition? Or if the day after filing marked the child’s seventeenth birthday, or the loss of child custody? Under these hypothetical scenarios, the component-focused method would result in the entire child tax proceeds being considered pre-petition interests. The traditional ‘pro rata by days’ method of allocation could provide greater benefit to debtors in these scenarios.

Child Tax Credit Exemptions Under State Law

If the CTC refund is estate property, the debtor may protect the proceeds as exempt, depending on state law. The federal exemption scheme does not provide specific relief to debtors seeking to exempt CTC proceeds. 11 U.S.C. § 522(d)(a) allows debtors to exempt from the bankruptcy estate a “local public assistance benefit.” Because this exemption is limited to “local” benefits, the federal exemption does not cover relief programs created by the federal government. But in 1979, the Commissioners of Uniform State Laws recommended changing “local public assistance benefit” to “federal, state, or local public assistance legislation.” Accordingly, several states created broader “public assistance benefit” exemptions by removing the modifier “local,” including Missouri,[27] Illinois,[28]  Iowa[29] and Kentucky.[30] The states that dropped the “local” modifier provide the greatest hope to debtors seeking to exempt CTC proceeds. Debtors in these states may rely on an Eighth Circuit opinion, In re Hardy.[31]

In Hardy, the Eighth Circuit ruled in favor of a chapter 13 debtor who sought to protect her interest by utilizing a state exemption.[32] The debtor claimed that $2,000 of a tax refund attributable to the Child Tax Credit statute was exempt under Missouri law as a “public assistance benefit.”[33] The debtor argued that Congress designed the ACTC specifically for “needy” families.[34] The bankruptcy court, bankruptcy appellate panel and Eighth Circuit all concluded that “public assistance benefits” mean government benefits for the “needy,” but distinguished the CTC from traditional public assistance as providing a benefit not only to those in need, and disallowed the debtor’s use of the state exemption for this purpose.[35] The BAP affirmed in part, reasoning that a relatively affluent family could benefit from the ACTC just as a lower-income family could, and as such, agreed that the public assistance exemption was improper.[36] The Eighth Circuit reversed, largely because it found congressional intent “to benefit low-income families” through providing for the ACTC.[37]

The Eighth Circuit’s reasoning in this opinion articulated that it did not matter whether the ACTC could be considered a public assistance benefit or not. In reversing the lower courts, the Eighth Circuit concluded that the breadth of conflicting decisions did not take “into account the various amendments to the ACTC, and the legislative purposes behind those amendments.”[38]

In interpreting Kentucky’s similar “public assistance benefits” exemption, the U.S. Bankruptcy Court for the Western District of Kentucky attempted to strike a balance between these two positions: “[E]ven though the primary purpose of the [Child Tax Credit statute] is not to benefit low income families, the credit is still intended to benefit this group.”[39] Accordingly, the court examined the specific circumstances of the debtors to determine whether they were “needy” enough for Child Tax Credit statute proceeds to convert into a form of public assistance.[40] Under Kentucky law, a child is considered to be low-income if they are deprived of (1) parental support by reason of death, continued absence, incapacity or unemployment; and (2) “a level of subsistence that is compatible with decency and health.”[41] The debtors in this case did not qualify as “needy” under this second prong, because their income exceeded the Federal Poverty Guidelines by approximately $18,000.[42]

Conclusion

Debtors with tax refund proceeds attributable to the Child Tax Credit statute must first distinguish between the CTC and ACTC. If a significant portion of the refund is attributable to the ACTC and the debtor lives in a state that exempts “public assistance benefits,” the debtor is in a strong position to claim the ACTC as an exempt public assistance benefit. But if the debtor lives in a state without this type of exemption, or has proceeds only attributable to the CTC, the debtor can argue that their CTCs, as a nonrefundable credit, do not constitute property of the estate.

If the debtor cannot claim an exemption, then the debtor must examine the components of their eligibility for this form of tax relief. If eligibility events arise post-petition, such as the birth of a child or realization of gainful employment, refunds attributable to these events under the statute would be considered post-petition interests under the component method of attribution. If, on the other hand, the debtor loses qualifying “components” after filing the bankruptcy petition, the debtor may be better served by utilizing the pro rata-by-days attribution method. Ultimately, varying positions on the meaning of estate property, the calculation of attribution and applicable state exemptions require the consumer debtor with CTC proceeds to carefully consider a number of factors when preparing to file a bankruptcy.