Wednesday, December 17, 2008

Are Pre-Petition Income Tax Refunds Which Debtors Had Irrevocably Elected to Apply to Future Tax Liabilities Nevertheless Still Estate Assets?

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

Nichols v. Birdsell
Ninth Circuit Case No. 05-15554
May 9, 2007

Issue of First Impression for Ninth Circuit

Are pre-petition income tax refunds which debtors had irrevocably elected on their tax returns to apply to the next year's taxes assets of their bankruptcy estate? Or as the Court put it, does "debtors’ pre-bankruptcy application of their right to tax refunds to post-bankruptcy tax obligations constitutes an asset that must be turned over to the bankruptcy trustee pursuant to the Bankruptcy Code, 11 U.S.C. § 542?"

Facts and Procedural Status
Debtors overpaid state and federal personal income taxes for 2001, and instead of requesting tax refunds they elected to apply these overpayments to future tax liabilities. Within days of making that election early in 2002, debtors filed a bankruptcy (presumably under Chapter 7 although the opinion does not say so explicitly). A year later, after disregarding the trustee's demand to pay the amount of these overpayments to the estate, the debtors sought to apply the overpayments to their 2002 state and federal tax liabilities. The trustee filed an adversary proceeding for recover of the overpayments, "arguing that the Debtors’ interest in the tax overpayments was property of the bankruptcy estate pursuant to 11 U.S.C. § 541 that must be turned over to the Trustee under section 542." The bankruptcy court agreed, granting summary judgment for trustee, and the district court affirmed.

Debtors' Argument
The debtors pointed to §§ 6402(b) and 6513(d) the Internal Revenue Code which provides, as the Court worded it, for an "irrevocable election applying an overpayment of taxes to the subsequent year’s tax obligation." Thus with their election, they argue, the character of the overpayments changed into estimated payments for the 2002 tax liabilities, leaving nothing in their estate at the time of their bankruptcy filing. After their irrevocable election debtors had no ability to get the funds back from the IRS (presumably also from the state), and so that also "prevents the bankruptcy estate from asserting any right to the funds."

The Code Sections
§ 541, entitled "Property of the estate," describes "property" as “all legal or equitable interests of the debtor in property as of the commencement of the case.”

§ 542, entitled "Turnover of property to the estate," states in pertinent part:
an entity . . . in possession, custody, or control, during the case, of property that the trustee may use, sell, or lease under section 363 of this title, or that the debtor may exempt under section 522 of this title, shall deliver to the trustee, and account for, such property or the value of such property, unless such property is of inconsequential value or benefit to the estate.
The Rationale
As an issue of first impression in the Ninth Circuit (and perhaps in many other Circuits as well since the Court did not cite any other Circuit's opinions), this opinion relied very heavily on its own 2000 opinion In re Feiler, 218 F.3d 948, in the context of net operating loss carrybacks and carry forwards. In that case the debtors elected not to exercise their option to carry back their net operating losses and create a current tax refund (of $280,000!) but rather elected to carry these losses forward to reduce tax liabilities in future tax years. The IRS there refused to refund these funds to the bankruptcy trustee on the grounds that the debtors' election was irrevocable, the trustee sued the IRS, the bankruptcy court granted summary judgment in favor of the trustee, and the Ninth Circuit upheld that judgment. The Court here acknowledged that Feiler differs from the instant case not only that it involves different tax elections, but also that it dealt with the trustee's powers to avoid debtor's tax election as a fraudulent transfer under § 548 instead of whether the prepayment of taxes from prior tax years constitutes estate property under § 542. Yet the Court focused on its broad definition of "property" in Feiler, having held there that “[b]ecause the right to receive a tax refund constitutes an interest in property, . . . the election to waive the carryback and relinquish the right to a refund necessarily implicates a property interest.” And it recalled that Feiler had relied on a 1966 U.S. Supreme Court case, Segal v. Rochell, 382 U.S. 375, for the point that "the term property has been construed most generously and an interest is not outside its reach because it is novel or contingent or because enjoyment must be postponed.”

The Holding
From this the Court held that the debtors' inability to get the overpayments back from the IRS because of their irrevocable election does not prevent those overpayments from being assets of the bankruptcy estate. Estate assets include all debtors' interests "even in circumstances in which the interest cannot be liquidated and transferred by the debtor."
In light of the expansive definition of property contained in the Bankruptcy Code and our broad interpretation of “property” under Feiler, we hold that this credit toward future taxes constituted estate property at the time the Debtors filed for bankruptcy.

by Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys

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