Juggling in Defense of the Tax Refund

protecting tax refund

As long as clients use tax withholding as a form of savings account, bankruptcy lawyers will have to juggle to protect that refund when bankruptcy looms.

Limber up, and let’s look at a fact pattern I faced with a December client who needed to file, but faced no immediate crisis.

The point for analysis was protecting the tax refund for the year of filing from competing claimants.

Tax refund is property of the estate

Unfortunately, courts treat any tax refund for the year of filing as property of the estate, even though the amount isn’t liquidated nor is it due when the case is filed. Barowsky.

The timing question in my case arose mid December, so time was too short to eliminate or reduce the anticipated refund. Defeating the trustee’s claim to the refund after you file.

So, whether we filed in December, during the current tax year, or in January, after the close of the current year, the refund was exposed to turnover to the trustee (or inclusion in the liquidation analysis in a Chapter 13).

Exposure to offset

The next point for analysis was the possibility of offset by the Feds for an outstanding SBA loan. A quick review of the law confirmed that the SBA has the right to set off (or “offset,” I never know which is better). See 31 USC 3720A (c).

Federal regs spell out a debtor’s rights when faced with threatened offset on account of a debt to a federal agency. See 13 CFR ยง 140.3

So, if we wait to file my client’s case til the close of the tax year, the SBA can be expected to intercept the refund to satisfy in part the outstanding loan.

The trustee loses to the SBA, or gets only the excess of the refund over the SBA claim, and the SBA profits.

Which would be a shame, since the debt to the SBA is a dischargeable debt.

Defeating the right to offset

But what if we could defeat the SBA’s right to offset? Offset requires mutuality: debts held by each party in the same capacity.

The Bankruptcy Code deals with the right to set off in Section 553, providing in part

…this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case…

The IRS’s obligation to refund tax overpayment arising at the close of the tax year, even though the amount of the refund can’t be calculated until all the tax forms are in and analyzed.

So, if my client files before the end of the tax year, the IRS’s obligation arises after the commencement of the case. And the debtor’s obligation to the SBA arose before the commencement of the case. The SBA is out of luck, or really, out of mutuality.

Exemptions to the rescue

In my case, the available exemptions and the client’s meager assets will combine to allow us to exempt the refund, and cut the trustee out.

So, it feels like a good day when I can out maneuver both the trustee and the federal government.