Tax Overpayments in Bankruptcy

Taxpayers who owe taxes and who are thinking of filing bankruptcy should be aware of the Ninth Circuit’s recent Nichols v. United States case.

The taxpayers in the Nichols case overpaid their 2001 state and federal tax liability. The court opinion says that:

Sixteen days later, on February 5, 2002, the Debtors filed for bankruptcy. The [Bankruptcy] Trustee demanded that the Debtors turn the deposits over to the Trustee, but this was not done. In February of 2003, the Debtors signed their 2002 federal and state income tax returns and applied the deposits (resulting from the overpayment of their 2001 taxes) to their 2002 tax liabilities.

The Bankruptcy Court held that the overpayment was an asset of the bankruptcy estate; therefore, the taxpayers had to deliver an amount equal to the tax overpayment to the trustee.

The taxpayers appealed the decision, arguing that their inability to get the funds back from the IRS and the irrevocable nature of their election prevents the bankruptcy estate from asserting any right to the funds.

The court rejected the taxpayer’s argument, saying:

As a result of the election, the Debtors were left with a credit with the IRS that provided a dollar-for-dollar tax reduction in the following year. If the Nichols had not elected to prepay their taxes, those funds would have been refunded to them and would likely have been available for the bankruptcy estate when they voluntarily filed for bankruptcy just 16 days later. The fact that the election, once made, was irrevocable, does not change the analysis. In light of the expansive definition of property contained in the Bankruptcy Code and our broad interpretation of “property” …, we hold that this credit toward future taxes constituted estate property at the time the Debtors filed for bankruptcy.

Perhaps the result would have been different if the taxpayers had relinquished any rights in IRS and state tax deposits prior to filing for bankruptcy.