Tax Refunds in Bankruptcy

TAX REFUNDS IN BANKRUPTCYThe treatment of tax refunds is a popular issue in bankruptcy.  Income tax refunds are commonly considered to be part of the bankruptcy estate.  Therefore, if a debtor files Chapter 7 bankruptcy, the trustee may attempt to seize all or a portion of the debtor’s tax refund.  In a Chapter 13 bankruptcy, the trustee may seek to have the debtor turn over all or a portion of the debtor’s tax refund, to be applied towards the funding of the Chapter 13 plan.

However, a tax refund as an asset in bankruptcy may be entitled to various State or Federal exemptions that can protect the refund from seizure from a bankruptcy trustee in a bankruptcy.  Additionally, such exemptions may also protect a debtor who does not file bankruptcy from seizure from a creditor or creditors.

  • The earned income tax credit is a form of payment that is the subject of attempted seizure by both bankruptcy trustees and creditors.  A debtor may be able to claim certain exemptions to protect the earned income tax credit.  Such exemptions may apply under either State or Federal law.  In bankruptcy, whether one is able to claim either the Federal or State exemption is determined by whether the State has opted to apply Federal or State exemptions, or both, in its protection of its residents.

The earned income tax credit was purportedly created to provide a benefit to lowering income persons and families.  The earned income tax credit reduces the amount of taxes the tax filer needs to pay.  If the earned income tax credit is in excess of the tax liability of the tax filer, the filer will receive the excess amount in the form of a refund.

There is no Federal exemption that specifically addresses the earned income tax credit.  There is what are referred to as standard exemptions that may be applied towards the protection of the earned income tax credit.  The federal exemptions include a wildcard exemption of $1,225 and an exemption that provides a maximum of $11,500 of any unused portion of the homestead exemption.

Indiana and Florida have exemptions that specifically address and protect the earned income tax credit.  In each of these States, there is no limit as to the dollar amount of the earned income tax credit which is protected from either the bankruptcy trustee or a creditor.

Although some States do have exemptions that specifically apply to the earned income tax credit, the child tax credit may not be similarly protected.  While a debtor may be able to exempt the earned income tax credit in Florida, Florida does not have a statute or exemption that specifically applies to the child tax credit.  The debtor may protect the child tax credit from seizure or attachment by a bankruptcy trustee or creditor through the application of another Florida exemption, such as the Florida wildcard exemption or the personal property exemption.

The majority of the States have an exemption for what is referred to as “public assistance.”  The federal exemptions additionally provide for a “local public benefit” under section 522(d)(10)(A).  Although the writer has found no evidence that a federal court has determined that this exemption applies to the earned income credit or the child tax credit, one could argue that the exemption should properly apply because of the function and purpose of these two forms of tax credits.

The case of In Re Hardy involved a debtor, Pepper Hardy, who filed a Chapter 13 bankruptcy in 2012, in Missouri.  The State of Missouri opted out of the Federal Exemptions, and therefore only the State of Missouri exemptions could be applied in Ms. Hardy’s Chapter 13 bankruptcy.

In her bankruptcy petition, Ms. Hardy exempted the portion of her tax refund that applied to the child tax credit, using Missouri’s exemption for a “public assistance benefit.”  The Chapter 13 bankruptcy trustee objected to the debtor’s use of this exemption and the bankruptcy court agreed, holding that the Child Tax Credit was not a form of public assistance, as the credit is available to both financially poor and wealthier taxpayers.  The Child Tax Credit at the time of the bankruptcy hearing was available to any head of household whose annual adjusted gross income was less than $75,000 and to married-joint filers with income less than $110,000.

The Bankruptcy Appellate Panel affirmed the lower bankruptcy court decision, determining that because the child tax credit also benefits persons not considered to be financially poor, such benefit could not properly be considered a public benefit.  The case was appealed to the Eight Circuit Appellate Court, which examined the legislative intent of the Child Tax Credit, including the commentary of Senator Baucus who stated, “We increase the amount of the child tax credit that is partly refundable so that lower income families can benefit from the credit as well.”  Congress had also amended the Child Tax Credit provision numerous times, and each time the benefit shifted more towards those with lower income.  The Eighth Circuit held that although higher income persons could receive a benefit from the Child Tax Credit, the majority of those benefitted were lower income persons, and therefore the benefit that accrued from the Child Tax Credit could be considered a “public assistance benefit.”

While the earned income tax credit may not be specifically exempt depending on what exemptions are used within a given jurisdiction, this does not mean the bankruptcy filer is without remedy.  One option is to spend the earned income tax credit or tax return, before filing the bankruptcy.  In such an instance, the debtor should spend the tax refund for what are called normal living expenses.  Normal living expenses include such expenses as clothing, food, gasoline, housing, necessary repairs, bankruptcy attorney fees, and other such expenses.  The bankruptcy trustee cannot take the tax refund because it is already spent.

This remedy applies more clearly to an individual who files Chapter 7 bankruptcy.  However, in a Chapter 13 bankruptcy where the debtor is obligated to tender payments to the Chapter 13 trustee over a period of up to five years, this solution is less available.  The Order Confirming the Chapter 13 plan may provide that the debtor must turn over his or her tax refund to the Chapter 13 Trustee.

One option may be to provide for the “income” received pursuant to the tax refund in the Chapter 13 plan and budget.  For example, a debtor that commonly receives a tax refund of $5,000 could provide in the income portion of the bankruptcy petition, a monthly “income” pursuant to the tax return of $416 or $5,000 divided by 12.  Since this income is already provided for in the budget, the trustee and bankruptcy court should properly determine that seizure of the tax refund is inappropriate.  The Chapter 13 trustee does not seek seizure of the debtor’s regular income, as such income is provided for in the budgetary portion of the bankruptcy petition.  Likewise, if the debtor’s budget provides for a monthly determination of the anticipated tax refund, the Chapter 13 Trustee should not be justified in seeking seizure or attachment of the debtor’s tax refund.

Additionally, if the debtor is a below median filer, and so provides for the anticipated tax refund in the budgetary portion of the bankruptcy petition, meaning schedule I and the B23, the debtor may be able to not only be able to retain his or her tax refund in full, but also may be eligible for what is referred to as a zero percent plan.  A zero percent plan is a Chapter 13 plan that provides no monies to the unsecured creditors.

For example, if the median income for bankruptcy purposes for a single filer is $45,000, and the debtor has annual income of $30,000, and generally receives a tax refund of $3,000, even if the $3,000 is considered additional income or a windfall, the debtor still only has annual income of $33,000.  This is income total far below the median and would qualify the debtor for a zero percent plan, based upon a determination of income alone.  Other factors, such as the debtor owning or possessing certain non-exempt assets may require the debtor to pay more than zero to his or her unsecured creditors, but in this example, the illustration is made by examining only the income of the debtor.

Another possible option is to avoid receiving a tax refund by filing an amended IRS Form W-4 with one’s employer and reducing the amount of tax withholding from one’s salary.  The success of these techniques is not assured, and one should examine how such techniques may be treated within their respective jurisdictions.

The above remedies are to be considered more proposals than remedies.  The ability of the debtor to employ these remedies may differ according to the jurisdiction in which they file.

For debtors seeking to protect their tax refunds from creditors outside of bankruptcy, in the State of Florida, there are remedies.  In the State of Florida, if one’s bank accounts are garnished after the entry of a judgment, there is no requirement that the debtor receives any notice of the garnishment until after the monies are either removed, or a hold has been placed on the account.  The creditor is required to send you a copy of the writ of garnishment, a copy of the bank’s answer filed by the bank, and information regarding your right to request the court stop the garnishment.

Upon notification of the garnishment or hold on the bank account, the debtor may file a claim of exemption with the court.  If the monies in the account were supplied by a refund pursuant to the earned income tax credit, for example, one should cite the applicable section of Florida law, and file such affidavit with the court and the attorney for the judgment creditor.  The creditor must then file a response within two days.  The debtor may request a hearing to end the garnishment and seek the return of any exempt monies.

Under Florida law, it appears that the creditor is under no duty to investigate whether monies contained in a bank account are exempt under Florida law, before garnishing the account.  If however, a creditor garnishes a bank account which it knows contains exempt monies, the creditor may be subject to certain damages or fines.  A debtor who receives a tax refund, containing a sizable portion representing the earned income tax credit, may place the portion of the tax refund representing the earned income tax credit in a bank account titled, for example, the “earned income tax credit account”.  If a creditor, upon examining the accounts of the debtor, attaches or garnishes such a titled account, the debtor could argue that the creditor knowingly violated the State of Florida exemption laws, and possibly seek damages from the creditor.

A number of additional cases have addressed the various issues surrounding the treatment of tax refunds in bankruptcy.  In Re Sanderson was a 2002 case decided by the late Alexander L Paskay.  In Sanderson, the debtors claimed two income tax returns exempt pursuant to Florida Statute 222.25.  The bankruptcy trustee objected to the exemption, arguing that no portion of the tax refunds represent an earned income tax credit and the tax refunds claimed are not shown to include monies provided through the earned income tax credit.

Judge Paskay included in his decision a discussion that prior to June 1, 2001, tax refunds were often claimed as exempt under Florida Statute 222.11, upon the argument that tax refunds were wages earned but not received, by the head of household.  The Judge continued that in interpreting this Statute, the courts have held that tax refunds were not wages but a chose of action, and the fact that the refund was based upon an excessive withholding of the wages of the debtor during the tax year was of no importance.  Wages are paid by the employer and a tax refund is paid by the government.  The claim is against the government and not the debtor’s employer.  Paskay summarized the case by stating that although monies representing the earned income tax credit would properly be exempt pursuant to Florida Statute 222.11, there is no showing that the monies received by Sanderson were received pursuant to the earned income tax credit.  The tax refund was a “plain vanilla income tax refund.”

Another case in the Middle District of Florida Bankruptcy Court was the matter of Tara S Wharton-Price.  In Price, the debtor held a bank account into which she deposited her 2014 tax refund in the amount of $4,700.  Of the $4,700 tax refund, approximately 63% was attributable to the debtor’s earned income tax credit.  Prior to filing the bankruptcy, the debtor spent roughly $1,734 of the refund, with $2,965 remaining in the account.  The debtor argued that the $2,965 remaining in the account represented the earned income tax credit, protected under Florida Statute 222.25(3).

Florida Statute 222.25(3) provides that debtors in Florida may claim an exemption in an “interest in a refund or a credit received or to be received, or the traceable deposits in a financial institution of a debtor’s interest in a refund or credit, pursuant to section 32 of the Internal Revenue Code of 1986 as amended [the Earned Income Credit].

Because the debtor did not separate the Earned Income Credit portion of the refund from the remaining portion of the refund, the court was unable to directly determine which portion represented the Earned Income Credit.  However, the court considered one of three approaches generally used in determining what portion of the monies should be deemed exempt.

The lowest intermediate balance test holds that the debtor withdrew only the non-exempt portion of the tax refund, leaving the remaining monies representing the earned income credit.  The straight percentage test holds that one should determine what percentage of the total refund represented the earned income credit, and therefore any monies remaining in the account, should be apportioned based upon their respective percentage of the total refund.  A third is the first in, first out approach, which is often used when there are deposits and withdrawals after the initial deposit of the tax refund.

The court held that the straight percentage approach, which was fashioned in the case of In re Ross, was the fairest approach.  Therefore, 63% of the remaining monies in the account were representative of the earned income credit, and therefore exempt pursuant to Florida law.

In re Cook was a 2012 bankruptcy court case decided in the Northern District of Alabama.  Although Alabama did not have a specific exemption that applied to the Earned Income Credit, the court held that the State exemption governing public assistance could be applied in protecting the portion of a tax refund attributable to the Earned Income Credit.

The Alabama court also addressed another issue relating to tax refunds in bankruptcy.  Although a tax refund, and the earned income credit, may be properly claimed as exempt by a debtor in bankruptcy, another hurdle posed is the matter of disposable income.  Bankruptcy code section 1325(b)(2) provides that disposable income “means current monthly income received by the debtor (other than child support payments, foster care payments, or disability payments for a dependent child made in accordance with applicable nonbankruptcy law to the extent reasonably necessary to be expended for such child) less amounts reasonably necessary to be expended [for certain maintenance and support obligations, charitable contributions, and business expenditures].  Additionally, current monthly income “excludes benefits received under the Social Security Act, payments to victims of war crimes or crimes against humanity on account of their status as victims of such crimes, and payments to victims of international terrorism.”

The debtor in Cook proposed in her Chapter 13 plan to turn over her federal income tax return to the Chapter 13 trustee, minus the amounts attributable to the earned income credit.  The court held that the earned income credit is income under the Bankruptcy Code and must be included in the calculation of the debtor’s current monthly income.  Additionally, since the earned income credit is not child support payments, foster care payments or disability payments for a dependent child, it is also included in disposable income.

The lesson found in Cook is that although a debtor’s tax refund, and in particular, the earned income credit, may found to be exempt under applicable State law, or even Federal law, the court will consider such funds to be disposable income that can influence the amount of monies the debtor will need to contribute to a confirmable Chapter 13 plan.

The United States Bankruptcy Court case for the Southern District of Iowa of Angela M Davis also addressed the treatment of tax refunds in bankruptcy.  Ms. Davis filed a Chapter 7 bankruptcy in 1991.  The debtor sought to exempt an earned income tax credit of $953, arguing the refund ought to be exempt under the State exemption statute as “public welfare”.

The court determined that the earned income credit did qualify under the public welfare exemption.  In making its decision, the court looked at the purpose for the creation of the earned income credit, writing “The earned income credit was enacted to reduce the disincentive to work caused by the imposition of Social Security taxes on earned income…to stimulate the economy by funneling funds to persons likely to spend the money immediately, and to provide relief for low-income families hurt by rising food and energy prices.”

The purpose behind the enactment of the earned income credit closely aligns with the basic purposes served by the exemption laws which are to provide a debtor sufficient money to survive, afford a means of financial rehabilitation and to protect the family unit from impoverishment.  Additionally, the Trustee made no argument that the earned income credit was not a local public assistance benefit.  Therefore, the court determined that the earned income credit should be exempt under the State exemption statute governing public welfare.

Jay Weller is a bankruptcy attorney practicing in the Tampa Bay area.  Since 1993, Mr. Weller has almost exclusively practiced bankruptcy law.  Weller Legal Group PA represents only debtors in bankruptcy proceedings, primarily Chapter 7 bankruptcy and Chapter 13 bankruptcy.  Weller Legal Group PA is considered by many to be the premier bankruptcy law firm in the Tampa Bay and surrounding regions.  Weller Legal Group is the oldest remaining law firm in the Tampa Bay area with multiple offices, including offices in Clearwater, Port Richey, Brandon, and Lakeland.  If you are seeking representation in bankruptcy proceedings, please contact us through our website, at or by contacting us via telephone, at 727-539-7701, or 1-800-407-3328 (DEBT).

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