The bankruptcy-tax rules can present a number of opportunities. In Martin v. United States, Case No. 3:13-CV-03130 (C.D. Ill 2017), the court concludes that the taxpayers retained the right to sue the IRS for substantial tax refunds for taxes that were overpaid prior to their bankruptcy, despite having discharged their debts in bankruptcy.
Bankruptcy & Tax Refunds, Generally
Typically, a taxpayer will want to include unpaid tax debts in their bankruptcy case. With a Chapter 7 bankruptcy, this may allow the unpaid taxes to be discharged. With a Chapter 13 case, this will allow the unpaid taxes to be paid through the bankruptcy rather than surviving the bankruptcy.
The motivations for tax overpayments or refunds may be different. If the tax refund is included in the bankruptcy, it is part of the bankruptcy estate that is available to pay creditors. Pre-petition tax refunds received before the bankruptcy petition may be used to pay the secured creditors before the bankruptcy petition, with the aim of ensuring that it does to pay off the secured creditors first. Tax refunds received after the bankruptcy filing can be more problematic.
Taxpayers cannot simply fail to include a tax refund claim for taxes paid prior to the bankruptcy in their bankruptcy. To the extent the refund claim was not known at the time the bankruptcy was filed, the unreported tax refund claim remains an asset of the bankruptcy estate. The bankruptcy trustee is the party who has the ability to file the refund claim and to receive the proceeds. If the bankruptcy is already closed at the time the refund claims are discovered, the bankruptcy trustee has to re-open the bankruptcy to try to collect on the refund claims.
Martin v. United States
In Martin v. United States, the bankruptcy trustee did not file the taxpayers’ amended returns or tax refund claims. The taxpayers did. They did so before the bankruptcy case had been closed (they also filed corrected amended returns after the bankruptcy case had been closed). The IRS audited the refund claims and denied the claims (it appears that one of the tax years may have been allowed by the IRS, but this is not addressed in the court case). The IRS Office of Appeals also denied the claims. The taxpayers, not the bankruptcy trustee, then filed a lawsuit against the IRS to recoup the refunds. The bankruptcy trustee re-opened the bankruptcy case at that point. This was required given the undisclosed tax refund claims. The bankruptcy trustee then abandoned the tax refund claims (after giving creditors notice, etc.).
Can Taxpayers File Tax Returns and Bring Suit
The government moved to dismiss the taxpayers’ lawsuit, asserting that the taxpayers did not have standing to bring suit. This turned on whether the taxpayers, not the bankruptcy trustee, had the authority to file a refund claim, as the law requires taxpayers to file a refund claim prior to bringing a lawsuit to recoup the refund.
The law is not clear on this point. In reviewing this law, the court noted that once the bankruptcy trustee abandoned the refund claim, the refund claim reverted back to the taxpayers as if the bankruptcy case did not exist. Based on this, the court concluded that the taxpayers had the right to file the refund claims and to bring the lawsuit to collect on the claims.
The takeaway is that taxpayers who discover tax refunds during or after a bankruptcy case should file the refund claims, even if the bankruptcy trustee will not do so. It may help if timing-wise, as in Martin, the claims are disallowed by the IRS at the administrative level. This may encourage the bankruptcy trustee to abandon the claims, rather than incur the costs to pursue them. The abandonment will cause the refund claims to revert back to the taxpayer, rather than the bankruptcy estate.