Tuesday, July 17, 2012

Debtor's Tax Refund Used for Basic Living Expenses is Property of Debtor's Bankruptcy Estate and Subject to Seizure by Trustee.

In the bankruptcy case of Ellman v. Baer, 467 B.R. 635 (D.Md. 2012), the court addressed whether money from a tax refund should be exempt from inclusion in the bankruptcy estate (and thus kept under the debtor's control and out of the hands of the trustee) because such money was required for the debtor's "basic living expenses." Ultimately, the court ruled in favor of the bankruptcy trustee, holding that the debtor's tax refund, based on his pre-petition income, was property of the debtor's bankruptcy estate, and therefore subject to seizure by the bankruptcy trustee, despite debtor's claim that he used the refund for basic living expenses.

The debtor in Ellman v. Baer was a special education teacher in the Baltimore County Public Schools. Debtor filed a Chapter 7 bankruptcy petition in December 2010, at which time his monthly expenses exceeded his monthly income by approximately $1,200. Debtor received worker's compensation benefits from February through June in 2011, due to an injury sustained while he broke up a fight at work. Although debtor applied for disability retirement due to his injury, which deprived him the use of his left arm, he had no other source of income as of the month of September. Debtor received a federal income tax return of $15,827 in February 2011 for the year 2010, which he planned to use to support himself during the summer months when he does not work. The tax refund was the subject of this dispute.

The bankruptcy trustee contended, and the bankruptcy court agreed that the refund (minus exemptions available to debtor) was property of debtor's bankruptcy estate and therefore subject to seizure by the trustee under 11 U.S.C. § 541(a).

The debtor on the other hand wanted the court to look to the use to which a debtor puts a tax refund, rather than simply the fact that the money comes in the form of a tax refund. Debtor likened his case to Lines v. Frederick, 400 U.S. 18 (1970), which held that vacation pay was not part of the bankruptcy estate. So the debtor argued that his tax refund is required for his basic living expenses and was therefore out of the creditor's reach. Debtor asserted that he regularly used his tax refunds to pay his family's living expenses during the two and half months when he is not paid. Thus, debtor's use of the tax refunds makes such refunds comparable to the vacation pay in Lines that was excluded from the Line's debtor's bankruptcy estate.

The bankruptcy court began its analysis by citing Kokoszka v. Belford, 417 U.S. 374 (1974) in which the Supreme Court held that a debtor's tax refund was "property" within the meaning of § 70(a)(5) of the (now former) Bankruptcy Code. According to the Kokoszka Court, the purpose of § 70(a)(5) was "to secure for creditors everything of value the debtor may possess in alienable or leviable form when he files his petition." Next, the bankruptcy court considered debtor's argument but was not able to find a case in the Fourth Circuit or any other Circuit that supported the debtor's argument that a tax refund based on a debtor's pre-petition income is not to be property of the bankruptcy estate, UNLESS the debtor had irrevocably applied the tax refund to prepayment of future taxes.

The court conceded that the debtor was correct to point out that the one purpose of the Bankruptcy Code is to provide an individual with the opportunity to make a fresh start financially. However, for public policy reasons, the court determined that there are other important purposes of the Code, such as the gathering and distributing a debtor's assets to his creditors.

This holding seems to suggest that there are ways to exempt tax refunds from inclusion in a bankruptcy estate. For an analysis discussing these exemptions and strategies about how to obtain these exemptions, please eagerly await future blog posts!

Warmest Regards,

Austin J. Pollak

By: Austin J. Pollak (Austin's bio) . Austin is a summer associate at the Schaller Law Firm where he concentrates in consumer bankruptcy law.

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