Planning for Tax Refunds in Bankruptcy

Given that it is tax season, the In re Porter, No. 16-11831-BFK (E.D. Vir. 2017) case serves as a timely reminder that taxpayers who have unpaid tax debts and who are expecting sizeable tax refunds may benefit from timing the filing of their bankruptcy cases.

Facts & Procedural History

The facts and procedural history are as follows:

  • The taxpayer filed her 2014 tax return on April 4, 2016.
  • The tax return reflected a $4,169.00 tax refund.
  • The IRS set off the refund against the taxpayer’s unpaid taxes for 2012 on May 2, 2016.
  • The taxpayer filed Chapter 7 bankruptcy on May 25, 2016.
  • The taxpayer’s bankruptcy petition listed the tax refund as being exempt.
  • The taxpayer filed a motion to recover the tax refund claiming that the setoff was an illegal preference.

Right to Tax Refund as of the End of the Year

The IRS argued that the taxpayer had no right to the refund claim until the IRS set off the refund to satisfy the taxpayer’s unpaid tax debt. The court did not agree. It noted that the taxpayer had a right to the tax refund as of midnight on December 31, 2014, the last day of the taxable year, and the refund belonged to the taxpayer until the time the government issued notice and actually set off the refund on May 2, 2016.

IRS Setoff Allowed if No Improved Position

The IRS also argued that it did not improve its position by setting off the tax refund on May 2, 2016. The bankruptcy rules generally void a setoff that results in the creditor obtaining more than it would as part of the bankruptcy case if the setoff occurred within 90 days of the bankruptcy petition being filed. The court agreed with the IRS. Since the taxpayer filed her bankruptcy petition on May 25, 2016, 90 days prior to this date was February 26, 2016. As of February 26, 2016, the IRS owed the taxpayer and the taxpayer owed the IRS. So the requirements for the setoff had occurred prior to the 90 day pre-petition time period–even though the actual setoff occurred during the 90 day pre-petition time period.

The taxpayer argued that the IRS improved its position when the taxpayer filed its tax return on April 4, 2016, which was within the 90 days prior to filing the bankruptcy petition. The court did not agree. It noted that the tax return filling had not bearing on this issue, as the taxpayer had a right to the refund prior to this time, namely, as of December 31, 2014.

Conclusion

Issues involving tax refunds can be one of the most difficult aspects of bankruptcy and tax law. These rules rules require careful planning. Not only are they result in the loss of the tax refunds, they can also result in the bankruptcy case being converted or even dismised.

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