On its face, Diaz (Diaz v. Viegelahn , No. 19-50982 (5th Cir. Aug. 26, 2020)) is a pretty straightforward decision that struck down a local form plan as violating a below-median income debtor’s right to use her tax refund to finance necessary expenses for maintenance and support.
On a deeper level, it appears to highlight the complications of using the IRS to effect non-tax social policy.
In the lower courts
Annette Diaz was a single mother of two, earning about half of the median income for a Texas family of three. In her initial schedules and plan, she projected a tax refund of $9500, based on her prior year’s tax return. After she filed Chapter 13, it developed that she would receive a “tax refund” of $3261.
The district-wide form plan for the Western District of Texas provided that in every case tax refunds in excess of $2000 constituted disposable income which must be paid to the trustee. Debtors were permitted to retain the refund only if the plan provided for 100% payment to creditors AND the debtor filed a motion seeking to retain the excess of the refund.
Debtor amended her plan to provide that the actually 2017 excess tax refund would be amortized over 12 months, with one twelfth of the refund treated as income each month. She also amended her I and J to reflect that the “excess tax refund” was necessary for the living expenses of the family.
It’s worth noting that the amended expenses for this family of three included $410 for food and housekeeping supplies; $50 for clothes, laundry and dry cleaning; $40 for personal care and services; and a whopping $36 for recreation, newspapers, entertainment and books.
The trustee objected and the bankruptcy court denied confirmation, holding that the debtor could not propose a treatment for tax refunds that differed from the form plan. Debtor appealed, the district court affirmed, and the case went to the 5th Circuit.
Circuit court invalidates form plan provision
The appeals court began with Lanning and Section 1325(b)(2) which provides that a below median income debtor’s disposable income is “current income” less the full amount needed for maintenance and support. That is, the limitations on projected expenses that constrain an above median debtor don’t apply to a below median income debtor.
The court held that the one-size-fits-all provision of the Western District’s form plan dealing with tax refunds abridged a below median income debtor’s right to use the refund for reasonably necessary expenses.
The Circuit Court had no difficulty believing that the tax refund was necessary for maintenance and support.
Note that in the amended Schedule J filed by Diaz that contemplated use of the refund for living expenses, she increased her projected expense for clothing from $0 to $50; food for three from $360 to $410; and her recreation/entertainment expense from $0 to $36.
As the appeals court noted, those expenses were still well below the IRS National Standards. (Where I practice, a plan proposing no expenditures for clothing for two minor children for five years would have been held not to be feasible.)
Held, just like local rules, local form plans must be procedural only—they may not “abridge, enlarge, or modify any substantive right” such as the right to calculate current income using actual, necessary expenses.
But was this really a tax refund?
Former IRS counsel Marilyn Ames parsed Diaz for ProcedurallyTaxing.com, and makes a well reasoned case that the “refund” check Ms. Diaz was entitled to was, in truth, payment of the Earned Income Tax Credit. Ames calculates that Diaz’s total income tax liability was around $828. The EITC for a family of three was $3208, just about the amount of “refund” the Chapter 13 Trustee sought to share with the debtor’s family.
The Fifth Circuit failed to address at all the issue that the “refund” in question was in fact generated by the EITC. So we see that when Congress used the tax code to effect this anti poverty program, it muddied the waters in bankruptcy court.
Maybe, it makes little difference in the case of the EITC. I compared the 2020 EITC income cap for an unmarried adult with three children to the median income figure for a family of four in the current UST median income figures. In no state was the cut off for EITC greater than the median income. Put another way, recipients of the EITC were in every state below median income debtors.
Thus every debtor with EITC should be entitled under the holding of Diaz to deduct the reasonable and necessary expenses to support themselves and their dependents.
With the enactment of the American Rescue Plan and its child tax credit, this issue may become more frequent.