Can the Chapter 7 Bankruptcy Trustee Take the Refund From a Jointly Filed Tax Return?
As an experienced Denver bankruptcy lawyer and who practices in most areas of Colorado, I frequently encounter situations where one spouse (who typically owes most of the family’s unsecured debt or who has an upside down house in only his/her name) files for chapter 7 bankruptcy while the other does not.
An expected Federal or state income tax refund is deemed by the Bankruptcy Code to be included within the debtor’s bankruptcy estate, such that the chapter 7 trustee can compel that these funds be turned over to be later remitted to unsecured creditors. For this reason, and particularly as this issue usually arises in the first three months of the year, I will recommend that my client receive AND spend down the tax refund BEFORE the bankruptcy is filed in Colorado, such that the tax refund is excluded from the bankruptcy estate. Another strategy is for the debtor to lower the amount of income tax withheld from his/her paycheck such that a tax refund will not be expected (but be careful not to be liable to the IRS or Colorado State Department of Revenue for underpayment of income tax).
However, for many filers, waiting to receive the tax refund prior to filing for bankruptcy is simply not an option as the reason for filing may be quite pressing. For instance, a debtor may expect to receive a $500 tax refund but cannot afford to wait to receive the refund from the IRS as the mortgage lender may have scheduled a foreclosure sale date on the home for within a week after the client first contacts me.
Many jurisdictions (not including Colorado) follow the general rule that a tax refund is to be split equally between the filing and the non-filing spouse, such that the non-filing spouse’s portion of the tax refund is excluded from the bankruptcy estate. Depending on which spouse has the higher income, the 50/50 rule can work both ways for a debtor filing for chapter 7.
By contrast, Colorado follows the rule that a tax refund from a joint return must be prorated according to the spouses' income. The following cases have held that a tax refund, resulting from a jointly filed tax return, is determined not to be property of the estate if the refund is traceable to the income of the non-filing spouse. See Carlson v. Moratzka (In re Carlson), 394 B.R. 491 (8th Cir. BAP 2008); Kleinfeldt v. Russel (In re Kleinfeldt), 287 B.R. 291 (10th Cir. BAP 2002); In re Gartman, 372 B.R. 790 (Bankr. D. S.C. 2007). In these cases, the courts held that the chapter 7 trustee had no property or ownership claim as to the non-filing spouse’s pro-rated portion of a tax refund where such was clearly traceable to the non-filing spouse’s income. As such, the non-filing spouse’s portion of the tax refund was excluded from the filing spouse’s bankruptcy estate and, hence, from the claims of the chapter 7 trustee.