It is that time of year again where tax refunds become central to planning the timing of banrkuptcy filings for individual chapter 7 debtors. Bankruptcy attorneys typically delay filing until the debtor receives the tax refund and legitimately spends the funds. This does not mean paying friends or relatives any money from the tax refund.
But often the client cannot or does not want to wait. The issue I would like to discuss here is when one spouse files and there is a joint tax return, what is the share of the tax refund that the debtor can retain, and what portion is subject to the claim of the chapter 7 trustee? There is conflicting case law and this issue typically leads to a settlement with the trustee, but knowledge of the possibilites can help the bankruptcy attorney with the bargaining.
A debtor can claim that the funds are held as tenants by the entireties, owned as husband and wife. This would enable the debtor to retain the entire refund. The debtor can only claim this entitlement if there are no joint debts. Judge Hyman in In re Gorny, 2008 Bankr Lexis 3726(Bankr. S.D. FL 2008) held that a tax refund could be claimed as tenants by the entireties.(and see cases cited by the court)
But I suspect Gorny would reflect a minority review as to the right to receive a refund being exempt as tenants by the entireties. In re Rice, 442 BR 140 (Bankr M.D. FL 2010), based on 11th Circuit analysis and citing numerous cases, held that the right to the refund in a joint tax return must be allocated between husband and wife based on what each would be entitled to receive.
Debtor’s counsel should compare the percent of each spouse’s income to the total income as well as the amount of tax withholding or estimated taxes paid by each. If possible the debtor can provide alternate tax returns as if filing the return separately or jointly.
The allocation method is a double edged sword. If the debtor has lower income, then the debtor would be entitled to a lower percentage of the refund subject to the trustee’s claim. If the debtor had most of the income, the trustee would be entitled to most of the refund.
A final note. I have been discussing the right to receive a refund. What if the refund has been received and not yet spent, especially if deposited into a joint bank account? The argument for tenancy by the entireties becomes stronger.(I recall a case that specifically made this point, likely one of the numerous cases cited by Rice, but I will leave that to the reader to research)
Well, another final note. In Florida the earned income credit is exempt, but don’t mix this up with the child credit.