Does Withholding on Wages Convert the Wages to a Tax?

The U.S. Bankruptcy Court recently considered whether amounts withheld from wages in excess of the amount of the income tax liability owed is a refund of tax or a refund of wages. The case is In re Crutch, No. 15-44523-cec. (E.D.N.Y. 2017). The case is a reminder to those taxpayers who are considering bankruptcy that they may need to take steps to ensure that they do not receive tax refunds during their bankruptcy case.

Facts & Procedural History 

The dispute relates to a Chapter 7 bankruptcy.

The taxpayer’s only income during 2015 was from Social Security and their pension. New York law exempts Social Security and pension income from the bankruptcy.

The taxpayers wanted to exempt their 2015 state and IRS tax refunds from the bankruptcy.

The bankruptcy trustee asked the court to order the taxpayers to turn over the tax refunds.

What is a Tax Refund?

The taxpayers argued that the “tax refunds” were not tax refunds; they were a return of Social Security and pension income. If the taxpayers were correct, the income would retain its exempt status under New York and bankruptcy law. This would allow them to keep the tax refunds. If the bankruptcy trustee was right, the “tax refunds” would belong to and have to be turned over to the bankruptcy trustee.

The bankruptcy court considered New York law and a prior court case from the Tenth Circuit Court of Appeals. In considering these laws, the bankruptcy court concluded that the status as wages is lost once the wages were withheld as a tax. The key is withholding.

The case does not address whether the withholding was made in error or in an amount that was excessive.

The case does also not address tax refunds that stem from estimated payments made to the IRS for exempt income that is received. These payments do not have taxes withheld from them.

It is up to the taxpayer to pay estimated payments to the IRS. One is left wondering whether the act of remitting the payment to the IRS in an amount in excess of the amount of income tax owed would convert the overpayment to a tax refund in bankruptcy.

Tax Refunds in Bankruptcy Should be Avoided

Regardless, the message for taxpayers who are considering whether to file bankruptcy is that they need take steps to ensure that they do not generate a “tax refund” during the course of their bankruptcy case.

This may mean adjusting withholding amounts (and possibly estimated payments) or looking for ways to defer tax benefits to later years.

This may include electing to capitalize and depreciate or amortize property rather than deduct the expenses for the property immediately, foregoing loss carrybacks, or even paying some expenses after the close of the tax year. It may also involve accelerating the receipt of income or gains to earlier years.