At this time of year, many people filing Chapter 7 bankruptcy lose their not-yet-received income tax refund to the bankruptcy trustee.

The generally applied rule here in eastern Oklahoma is that if a person files his income tax return, then files Chapter 7 bankruptcy before he receives his income tax refund, the Chapter 7 trustee will likely demand turn over of the refund (except for any portion due to the earned income credit) when the debtor receives it if the refund is of a significant amount (generally $1,500 or more).

This is why I always make sure that my clients who expect to receive an income tax refund know that they need to get their refund in hand and spend it on reasonable and necessary expenses before filing their bankruptcy case. Or if my client just can’t wait to file, I at least want them to be aware that they will likely lose their refund.

Now there’s another option to consider for people needing to file bankruptcy but expecting to receive a sizeable income tax refund thanks to the recent case of Weinman v. Graves, 609 F.3d 1153 (10th Cir. 2010).

A person planning on filing Chapter 7 bankruptcy may want to consider applying this year’s income tax refund to next year’s tax liability.

In July 2007, prior to becoming Chapter 7 debtors, James and Kathryn Graves filed their 2006 tax return. Pursuant to that return, the Graveses were entitled to a $3000.00 tax refund. Instead of choosing to receive a current refund of that money from the IRS, the Graveses elected to leave those funds on deposit with the United States and apply the overpayment to their future tax liability. Two months after filing their tax return, the Graveses filed for Chapter 7 bankruptcy protection. The Chapter 7 trustee attempted to force the IRS to turnover the tax refund pursuant to 11 U.S.C. sec. 542(a)(5) but the bankruptcy court held against the trustee. Strike one! The Chapter 7 trustee appealed and the Bankruptcy Appellate Panel (BAP) affirmed the lower court’s ruling. Strike two! The trustee again appealed and the Tenth Circuit affirmed the BAP. Strike three! The trustee appealed to the United States Supreme Court which denied cert.

The Tenth Circuit held that the Chapter 7 trustee could not force the IRS to turnover the tax refund at the time the motion was filed. Instead, the trustee was only entitled to the portion of the refund that was attributable to prepetition earnings and remained after the refund had been applied to the following year’s tax liability. The court reasoned that the debtors’ election to apply the refund to future tax liability was irrevocable under section 6513(d) of the Internal Revenue Code. Therefore, the debtors’ interest in the refund, and consequently the estate’s interest, was limited to the remainder of the refund, if any, after it was applied to the debtors’ 2007 tax liability.

The Tenth Circuit’s holding in Weinman may allow debtors to shield their tax refunds from the bankruptcy estate, reducing the pool of assets that creditors would otherwise have been able to reach absent the refund-application election. Bankruptcy attorneys should inform their clients who are considering Chapter 7 to consider electing to apply tax overpayments to future tax liabilities before filing for bankruptcy in an attempt to preserve the refund so that they can use it to reduce their post-bankruptcy tax obligations.

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