Bankruptcy and Tax Refunds

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In re Kent Culp, Case No. 20-52558 (Bankr. E.D. Mich., July 29, 2021)

This recently issued case from the Bankruptcy Court for the Eastern District of Michigan addresses an interesting intersection of bankruptcy and tax law involving a Debtor’s tax refund.  The Debtor filed his bankruptcy case on December 23, 2020 (“Petition Date”).  Before the Debtor and his non-filing spouse, Conni Culp, filed a joint federal income tax return for 2018. In that tax return, the Culps claimed and requested a tax refund of $13,825.00. After the Petition Date, the IRS sent a check to the Chapter 7 Trustee, dated April 15, 2021, representing the 2018 tax refund, in the total amount of $14,415.09, which included interest of $590.09.

In the Motion, the Trustee contended that the entire 2018 tax refund, including the interest portion, was property of the bankruptcy estate. The Debtor disputed this assessment, contending that only 50 percent of the refund amount was property of the bankruptcy estate, while the other 50 percent was the property of the Debtor’s non-filing spouse.  The dispute between the parties concerns the method by which the Court should allocate ownership of the tax refund, as between the Debtor (and therefore the bankruptcy estate) and his non-filing spouse.

The Court analyzed the various approaches that bankruptcy courts have taken to determine the portion of joint tax refunds to which a debtor’s estate is entitled when a joint return has been filed with a non-debtor spouse.  The Court focused on two primary methods:  (1) the so-called “50/50 Rule”; and (2) the “Withholding Rule”.

The 50/50 Rule, whose applicability was urged by the Debtor, creates a presumption that each spouse contributed equally to the household, including nonmonetary contributions, and that, thus, the joint tax refund should be apportioned equally between the spouses. Some courts find that the presumption of equal ownership may be rebutted by demonstrating that the couple’s “present conduct or history of financial management” suggests separate fiscal affairs. At least one court has disagreed, explaining that equal ownership of a tax refund may be rebutted only by evidence of “a domestic relations court order or an enforceable, written, prepetition contract between the spouses designating alternative ownership of the refund.”  The 50/50 Rule is considered the minority approach.

Contrary to the Debtor’s position, the Chapter 7 Trustee contended that the Court should apply the majority rule, which is known as the “Withholding Rule.”  Under the Withholding Rule, the refund is allocated between spouses in proportion to their respective tax withholdings during the relevant tax year. Fundamental to the Withholding Rule is the premise that the filing of a joint tax return does not change the property rights between the spouses. Rather, courts employing the Withholding Rule have explained that spouses who jointly file tax returns have separate legal interests in any overpayment, the interest of each depending upon his or her relative contribution to the overpaid tax.

The Court acknowledged that authority was split.  In an unusual admission, the Court even admitted that it had employed both methods in prior cases.  After reviewing all of the cases cited by the parties and considering all of the approaches, the Court determined that the best and correct approach was the Withholding Rule.  As a result, the Court found that the entire 2018 federal income tax refund was property of the bankruptcy estate. This was because it was undisputed, and the Culps’ joint federal income tax return for 2018 clearly showed, that all of the income for that year was earned by the Debtor Kent Culp alone, and all of the tax payments, through withholdings and otherwise, were made by the Debtor Kent Culp alone. The Debtor’s spouse, Conni Culp, did not earn any income and did not make any tax payments toward the federal income tax for 2018. As a result, the entire right to the 2018 federal income tax refund was the property of the Debtor, Kent Culp, when he filed his bankruptcy petition in this case. Thus, the Court held that the entire refund was property of the bankruptcy estate, subject to any allowed exemption that the Debtor might have.

Application

When faced with this issue, practitioners should review decisions from their specific jurisdiction, as cases across the country take different approaches on this issue.  Marital property laws will likely play an important role in which rule a particular bankruptcy case applies.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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