Oftentimes, bankruptcy law and tax law collide. On July 29, 2021, the Bankruptcy Court for the Eastern District of Michigan considered a case, In re Culp,¹ of intersecting bankruptcy and tax laws pertaining to Debtor’s tax refund. More specifically, in this context of a jointly filed 2018 federal tax return, the court decided to apply a majority Withholding Rule to allocate the federal income tax refund entirely to the bankruptcy estate—finding that the right to the 2018 tax refund was wholly the Debtor’s property.
As discussed below, the issue involved in this case has been approached differently across the country; thus, if you find yourself in a similar predicament, find a practitioner who is knowledgeable and experienced with your specific jurisdiction’s approach, including any applicable marital property laws. In Maryland, for instance, when one spouse files bankruptcy, it is important to calculate each party’s share of the tax refund to ensure that the non-filing spouse gets his or her portion of the refund and not the bankruptcy trustee. The debtor and non-filing spouse should prepare a hypothetical “married filing separately” return to determine the amount of refund due the non-filing spouse as apportioned in the return.
In this case, Debtor filed his Chapter 7 bankruptcy case on December 23, 2020 (Petition Date). Before the petition date, Debtor and his non-filing spouse, filed a joint tax year 2018 federal income tax return. In that tax return, Debtor and his non-filing spouse claimed and requested a tax refund in the amount of $13,825. After the Petition Date, the Internal Revenue Service (IRS) sent a check for the entire amount of that refund, plus interest, to the Chapter 7 Trustee, dated April 15, 2021.
The bankruptcy Trustee asserted that the refund, plus interest, wholly belongs to Debtor and, thus, is bankruptcy estate property. Debtor disagreed, maintaining that 50% of the funds is property of the bankruptcy estate and the remaining 50% belongs to his non-filing spouse. Thus, the Bankruptcy Court for the Eastern District of Michigan embarked on a consideration of the proper method of allocation to be used in this case.
First the court noted that there are at least four different approaches employed by bankruptcy courts to allocate joint tax refunds.² However, in this case the court only focused on two of the four approaches: (1) the “50/50 Rule,” which Debtor believed applicable, and (2) the “Withholding Rule,” which the Trustee favored. The court acknowledge the authority is split, that no binding precedent exists, and that “several of the bankruptcy judges in this district have adopted and applied the 50/50 Rule in the past.”³
First, according to Debtor, the 50/50 Rule presumes that each spouse contributed equally to the household. As such, a joint tax refund is rightly apportioned equally between spouses. The court, citing In re McInerney,⁴ noted that:
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.”
On the other hand, an also citing In re McInerney, the Chapter 7 Trustee countered with the “Withholding Rule”—the majority rule—which allocates a refund:
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.’” Indeed, “[a] tax refund essentially represents a repayment by the government to the taxpayer of an overpayment made by the taxpayer.” Accordingly, that refund is the “property” of the taxpayer "who earned the income and overpaid the tax.”⁵
After analyzing the approaches, the court ultimately determined that the correct approach in this matter was applying the “Withholding Rule.” Accordingly, the court held that the entire 2018 federal income tax refund was the bankruptcy estate’s property. Specifically, the court emphasized that it was undisputed and evidenced on the 2018 tax return:
that all of the income for that year was earned by [Debtor] alone, and all of the tax payments, through withholdings and otherwise, were made by [Debtor] alone. [Debtor's] spouse, [. . .] 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 [Debtor] when he filed his bankruptcy petition in this case. Thus, the entire refund is property of the bankruptcy estate, subject to any allowed exemption that [Debtor] might have.
Bankruptcy law and tax law independent of each other can create challenging legal scenarios for parties involved—but when the two areas collide, complexity may increase exponentially. If you find yourself in a place where these areas have intersected, don’t wait to get professional assistance—especially in states that have yet to adopt a consistent approach to these tax issues. An experienced professional can help you prepare the strongest arguments to preserve as much of the tax refund as possible.