Unlike tax laws that establish a specific amount due, bankruptcy laws define what is not due. These conflicting policy objectives can lead to unique outcomes in cases of unpaid taxes.
For instance, what happens to taxes held by the IRS but not yet applied to a future tax liability when a taxpayer overpays their taxes and files for bankruptcy? Can they apply the overpayment to other tax liabilities after the bankruptcy? The court addressed this question in Nichols v. Birdsell, 491 F.3d 987 (9th Cir. 2007).
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Facts & Procedural History
The taxpayers in this case overpaid their 2001 state and federal tax liabilities. Rather than obtain a current refund of that money, the debtors elected to leave those funds on deposit with the United States and the State of Arizona.
The court opinion describes the facts as follows:
Sixteen days later, on February 5, 2002, the Debtors filed for bankruptcy. The [Bankruptcy] Trustee demanded that the Debtors turn the deposits over to the Trustee, but this was not done. In February of 2003, the Debtors signed their 2002 federal and state income tax returns and applied the deposits (resulting from the overpayment of their 2001 taxes) to their 2002 tax liabilities.
The Trustee moved for partial summary judgment on the amended complaint, arguing that the taxpayers’ interest in the tax overpayments was the property of the bankruptcy estate that must be turned over to the Trustee.
The taxpayers opposed the motion and also moved for summary judgment and argued that, after making the election, they were no longer entitled to a tax refund. They contended that the election to apply the deposits to future tax liabilities extinguished their interest in the tax refund and left no property interest for the bankruptcy estate.
The Bankruptcy Court held that the overpayment was an asset of the bankruptcy estate; therefore, the taxpayers had to deliver an amount equal to the tax overpayment to the trustee. This appeal followed.
The Bankruptcy Rules
When a bankruptcy petition is filed, the bankruptcy estate consists of “all legal or equitable interests of the debtor in property as of the commencement of the case.” These assets are set aside for payment to creditors, etc. as part of the bankruptcy.
This is set out in Section 542(a) of the Bankruptcy Code. Section 542(a) outlines the requirements for entities, other than custodians, in possession, custody, or control of property that the trustee may use, sell, or lease under Section 363 of the Bankruptcy Code, or that the debtor may exempt under Section 522 of the Bankruptcy Code. The section requires that such entities deliver to the trustee, and account for, such property or the value of such property unless it is of inconsequential value or benefit to the estate.
Section 541 of the Bankruptcy Code defines property as all legal or equitable interests of the debtor in property as of the commencement of the case. This includes all types of property, whether tangible or intangible, and whether or not the property is currently in the debtor’s possession or control. It is important to note that the definition of property under Section 541 is very broad and includes interests that may not be readily apparent or easily quantifiable.
Tax Overpayments in the Bankruptcy Estate
The taxpayers appealed the bankruptcy court’s decision, arguing that their inability to get the funds back from the IRS and the irrevocable nature of their election prevents the bankruptcy estate from asserting any right to the funds.
The court rejected the taxpayer’s argument, saying:
As a result of the election, the Debtors were left with a credit with the IRS that provided a dollar-for-dollar tax reduction in the following year. If the Nichols had not elected to prepay their taxes, those funds would have been refunded to them and would likely have been available for the bankruptcy estate when they voluntarily filed for bankruptcy just 16 days later. The fact that the election, once made, was irrevocable, does not change the analysis. In light of the expansive definition of property contained in the Bankruptcy Code and our broad interpretation of “property”, we hold that this credit toward future taxes constituted estate property at the time the Debtors filed for bankruptcy.
Perhaps the result would have been different if the taxpayers had relinquished any rights in IRS and state tax deposits prior to filing for bankruptcy.
The Takeaway
This case shows that taxpayers who overpay their taxes and apply the overpayment to future tax liabilities post-bankruptcy might be able to keep the overpayment as their property, but that if it is held by the IRS at the time the petition is filed, it becomes part of the bankruptcy estate. The decision underscores the broad definition of property under the Bankruptcy Code, which includes interests that may not be readily apparent or easily quantifiable. Taxpayers considering bankruptcy should be aware of the potential impact of pre-bankruptcy tax payments on their bankruptcy estate.
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