The Bankruptcy Code is supposed to provide a pathway to a fresh start for the “honest but unfortunate debtor.” 1 That fresh start is a discharge from specified types of debts so that the debtor is no longer legally obligated to repay them. Discharge, however, is only attainable if the bankruptcy code sections that deal with discharge and dischargeability are satisfied. This means that careful bankruptcy planning, in light of all requirements, is absolutely essential throughout the process.
Unfortunately, for an elderly couple (Debtors) in Michigan, their election to apply more than $40,000 in tax refunds to the tax year following their Chapter 7 bankruptcy filing was not legitimate bankruptcy planning. On April 17, 2023, the bankruptcy judge in the matter of In re Wylie: (1) determined that the Debtors had failed to satisfy Bankruptcy Code (BC) §727(a)(2)(B), and (2) denied their discharges on the basis that they intended to hinder the Chapter 7 trustee.2 Rather than obtaining a discharge, the Debtors remained obligated on their debts, and the trustee took their IRS refunds, as well. We review In re Wylie here as a cautionary tale—don’t let poor planning result in a denial of discharge.
As the Court noted, the Debtors began having serious financial trouble as early as August of 2018. This was a direct result of Mr. Wylie’s many years of serious health problems. The Court was clear that by August of 2018, Mr. Wylie was unable to work and continued to face serious health issues. The facts outlined in the case also establish that their tax returns were quite complex due in part to the sale of depreciated machinery and equipment.
Understandably, all of the above contributed to late filed state and federal returns.3 As for the tax year 2018 return, in October of 2019 (days before the six-month extension for filing expired), Debtors made a $13,000 installment payment to the IRS. The extension date came and went, and the return still wasn’t ready. In March of 2020, Debtors finally filed their joint 2018 federal income tax return almost one year late and approximately five months before filing in Chapter 7. However, the filing generated a refund rather than a balance due. Debtors elected to have their 2018 refund of approximately $39,000 applied to their 2019 tax liabilities. This choice was made upon the advice of their accountant, and because “the Debtors wanted to try to make sure they could pay their 2019 income taxes.”4
The Debtors filed their joint Chapter 7 petition in August of 2020, and then about three weeks later they filed their joint 2019 federal return.5 Yet again, the Debtors were entitled to a refund and they elected to apply it—nearly $41,000—toward their 2020 tax liabilities. Note that the refund attributable to tax year 2019 was a prepetition amount, because the end of the 2019 tax year, December 31, 2019, occurred before they filed their joint bankruptcy petition.
As part of their Chapter 7 filing, Debtors filed bankruptcy schedules, disclosing assets under penalties of perjury. The schedules triggered a trustee investigation, especially because they disclosed the $13,000 installment payment on the schedules but indicated that their tax refunds were “unknown.” This was problematic, because Debtors were aware that they were entitled to a $41,000 refund three weeks after filing the 2019 return. Moreover, Debtors continued to make this false representations at the meeting of creditors.
After investigating, the trustee filed an adversary proceeding to deny Debtors’ discharges. And the trustee continued to pursue denial of their discharges even after Debtors turned over the refund amount to the trustee.
Bankruptcy Code §727(a)(2) provides that the court shall grant a discharge unless:
the debtor, with intent to hinder, delay, or defraud a creditor or an officer of the estate charged with custody of property under this title, has transferred, removed, destroyed, mutilated, or concealed, or has permitted to be transferred, removed, destroyed, mutilated, or concealed [. . .] (A) property of the debtor, within one year before the date of the filing the petition; or (B) property of the estate, after the date of the filing of the petition.
First the judge considered the trustee’s contention that BC §727(a)(2)(A) applied to prevent discharge, because the 2018 refund transfers were made within a year before the date of the filing of the petition. The judge decided that the trustee failed to meet his burden of proving that the transfers were made “with intent to hinder, delay, or defraud" a creditor or the Trustee.”6 According to the judge, the Debtors’ only intent there was to ensure they had the funds necessary to cover their 2019 taxes.
The judge also found that even though the Debtors made false statements at the meeting of creditors, they were not made “fraudulently.” The judge considered it significant that the Debtors knew that the trustee would see their tax returns, stating that:
it was obvious, and the Debtors and their attorney knew, that those tax returns would reveal to the Trustee all of the exact and material details about the Debtors' rights to tax refunds. That persuades the Court that the Debtors could not possibly have intended to deceive or mislead the Trustee about their tax refunds when they made their false statements about them.7
The judge then reviewed the trustee’s position that the Debtor’s post-petition election to apply tax year 2019’s $41,000 refund to tax year 2020 taxes was a transfer of estate property made with the intent to hinder the trustee as described in BC §727(a)(2)(B). And the judge agreed. According to the judge:
Had the Debtors simply elected on their federal and state 2019 tax returns to receive their overpayments as tax refunds, rather than electing to apply the overpayments to 2020 taxes, the taxing authorities would have promptly paid the tax refunds. Instead, they did not pay the refunds until much later, as described below. This had the potential of forcing the Trustee to file adversary proceedings against the taxing authorities, to avoid the 2019 Tax Refund Transfers under 11 U.S.C. §549(a), as unauthorized post-petition transfers.8
Interestingly, the judge noted that the 2019 refund transfers “did not actually hinder or delay the Trustee in obtaining the tax refunds;” however, the Debtors’ intent to make sure their 2020 taxes would be paid in a post-petition context is an intent to hinder the trustee.
Filing a petition does not guarantee discharge. Debtors must act in good faith and follow all applicable rules along the way. This case is an example of the careful planning and appropriate guidance needed during the process. Even debtors who are basically “honest and unfortunate,” place their goal of discharge in jeopardy if planning is aggressive and fails to preserve the priority framework of the bankruptcy code.