ARE TAX REFUNDS SUBJECT TO TURNOVER TO CHAPTER 13 TRUSTEE

What happens to income tax refunds when a debtor files for Chapter 13 relief? This is an interesting question, indeed. First, distinguish as to tax refunds for income earned before filing of the Chapter 13, and tax refunds for income during the Chapter 13 commitment period. For example, debtor filed his Chapter 13 case on January 2, 2012 but is expecting to receive a tax refund of $10,000 for his 2011 tax returns. What will happen to the $10,000 refund? Does debtor get to keep the refund or should debtor transfer the refund to the Chapter 13 trustee? Ouch, that hurts! Most debtors plan on using tax refunds for emergency payments, or use refunds to pay for real estate taxes, so refunds are money that debtors are relying on for survival. If they lose the refund by filing Chapter 13, they might as well postpone filing the case until they receive the refund and use it up, if they have time to spare. But if they are filing a 13 to stop an imminent foreclosure, delaying filing is not an option.

The state where debtor lives controls the treatment of tax refunds.

This is because two courts reached divergent conclusions on the validity of a requirement, for the confirmation of a Chapter 13 plan that the debtor agrees to remit to the Chapter 13 trustee tax refunds received during the plan period. The Bankruptcy Court for the Northern District of Iowa ruled that an acknowledgement that Chapter 13 debtors have been required to sign in order to obtain confirmation of the debtors' Chapter 13 plan and that required debtors to submit all tax refunds, economic stimulus tax rebates, employment bonuses, or any other payments received during the plan period to the Chapter 13 trustee for the benefit of creditors, unless the court ordered otherwise, was inconsistent with Hamilton v. Lanning, 130 S. Ct. 2464 (2010) and would no longer be required. So, if debtor lived in Iowa, he gets to keep his tax refund of $10,000 even if he cannot exempt it. The Chapter 13 trustee cannot get his hands on the refund for the benefit of creditors.

But if debtor lived in California, the refund would be treated differently. In re Diaz, a Bankruptcy Court in the Central District of California concluded that while a tax refund received by a debtor post-petition but arising from prepetition earning is property, no income, and is not subject to turnover to the Chapter 13 trustee. However, tax refunds attributable to earnings during a Chapter 13 debtor's applicable commitment period must be turned over to the trustee because they represent an overstatement of an expense (meaning the refund is part of income).

In Los Angeles, it is still standard practice for the Chapter 13 Trustee to require that the debtor turnover to the trustee the first three years of tax refunds obtained during the plan period. This is true at least, for debtors who are over median income for the state. In this example, the California debtor must declare the prepetition tax refund of $10,000 and exempt it under the 703 wild card because the refund is treated as property, not income. The wild card is $21,000 but is available only if debtor has a maximum equity of $11,000 in his residence. Nowadays, having no equity in the residence is not a problem because many residences are upside down. To illustrate, debtor has a residence with a fair market value of $300,000. The first mortgage balance is $350,000. He owns a 2005 Lexus RX 300 with no liens on it. He expects a tax refund of $10,000 for 2011. He files for Chapter 13 on January 2, 2012, to stop foreclosure of his residence and to handle $80,000 of credit card debt, can he keep his $10,000 tax refund? YES, he can keep the refund but he must declare the refund in schedule B as a receivable and exempt the $10,000 in schedule C under 703.140(b)(5).