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Tax Refunds and the Disposable Income Test

Posted on Sep. 8, 2020

We welcome back occasional guest blogger Marilyn Ames, who like me is retired from the Office of Chief Counsel, IRS and who did a lot of bankruptcy work when she worked for the government. She discusses today a recent 5th Circuit case allowing the debtor to keep an earned income tax credit despite some local rules in Texas requiring her to turn a part of it over. Although the 5th Circuit does not base its decision on the fact that the refund resulted from the earned income tax credit, that fact plays an important role. Keith

As illustrated by the Covid-19 payments recently dispersed by the Internal Revenue Service and the use of the IRS to carry out portions of Obamacare, Congress frequently uses the IRS and the Internal Revenue Code as a means of administering social programs that have little or nothing to do with taxes. One of the problems of using the IRS to execute these types of programs is that courts assume that all provisions in the Internal Revenue Code are tax-related, which can, at worst, result in decisions at odds with the purposes of these programs, and at best, create precedent that fails to acknowledge Congressional intent.

The Fifth Circuit’s recent decision in the bankruptcy case of Matter of Diaz (found here or at 2020 WL 5035800) illustrates this issue. While the Fifth Circuit reached what is clearly the right conclusion under the Bankruptcy Code, it did so without recognizing why its decision was correct as a matter of policy. The Diaz case involves the amount of a tax refund that must be turned over as part of a Chapter 13 plan as disposable income, to be paid to general unsecured creditors. The bankruptcy court, the district court and the Fifth Circuit all failed to state why the debtor had a refund, but the Fifth Circuit does provide enough facts for an educated guess to be made that Ms. Diaz’s refund for 2017 resulted from the earned income credit. During 2017, Ms. Diaz worked as a medical assistant, and earned $2,644.16 per month, or a total of $29,791 for the year. During this year, she was a single parent with two children. She filed bankruptcy on December 1, 2017, but her bankruptcy schedules filed later included her refund for 2017 in the amount of $3,261. Assuming that Ms. Diaz filed a return showing three exemptions and claiming the standard deduction for a head of household of $9,350, her return for 2017 would have showed a taxable income of $8,291 and a tax liability of $828. Making another assumption that she qualified for the earned income credit, the EITC for 2017 would have been $3,208, or about the amount of the refund she claimed on her return. (The tax liability on her return could have been offset by the child tax credit, resulting in a refund of any withholding, and she could also have been entitled to the additional child tax credit, but close enough given the facts available.)

Ms. Diaz filed bankruptcy in the Western District of Texas, which uses a standard form for Chapter 13 plans. Section 4.1 of the standard form provides that the debtor must turn over any tax refunds in excess of $2,000 to be disbursed to creditors pursuant to the plan by the Chapter 13 trustee. The only exception to turning over these funds is if the debtor’s plan provides for payment of 100% of the general unsecured claims, the debtor files a notice requesting that she be permitted to keep the excess refund amount, and the trustee does not object. Ms. Diaz could not make such a request, as her plan provided for only 12% of the general unsecured claims to be paid. Rather than filing a plan providing for the excess amount of $1,261 from her 2017 refund to be turned over to the Chapter 13 trustee, Ms. Diaz filed a plan that divided the total amount of her refund by 12 months, and then included that portion in her monthly income. Provision 4.1 of the standard form was then stricken through. When the refund was included as part of her monthly income, the plan was adequate to meet the requirements of the Bankruptcy Code.

This gerrymandering did not sit well with the Chapter 13 trustee, who objected to the plan as it did not meet the provisions of Section 4.1 of the standard plan. Ms. Diaz argued that the plan violated both the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure. The bankruptcy court and the district court for the Western District of Texas disagreed, holding that the district court had authority to require that a standard Chapter 13 plan be used pursuant to the provisions of Federal Rule of Bankruptcy Procedure 3015.1, and that tax refunds are disposable income under Bankruptcy Code § 1325(b)(2) that must be included in the plan. The bankruptcy court rejected the debtor’s argument that her tax refund was similar to payments received for dependent adult children that are excludable from a debtor’s disposable income, apparently not recognizing that all or part of the debtor’s refund was probably attributable to the EITC, which is computed based on the number of dependents a taxpayer has. The district court affirmed the ruling of the bankruptcy court with even less consideration of why the debtor was entitled to a refund. The bankruptcy court opinion can be found here (586 BR 588) and the district court opinion can be found here (2019 WL 4545613).

The Fifth Circuit disagreed that the debtor was required to turn over the refund, relying on Bankruptcy Code § 1325. If a plan does not provide for an allowed unsecured claim pursuant to § 1325(a), the plan cannot be confirmed unless the debtor includes all projected disposable income to be paid out to general unsecured creditors. Ms. Diaz’s plan did not provide for her unsecured creditors pursuant to § 1325(a), so she could only have a plan confirmed that included all projected disposable income. Noting that district courts may not adopt local rules or create standard plans that abridge, enlarge or modify any substantive right, the Fifth Circuit focused on whether the tax refund in excess of $2,000 was part of the debtor’s projected disposable income that had to be turned over to the Chapter 13 trustee.

Although the Bankruptcy Code does not define projected disposable income, § 1325(b)(1)(B) does state how it is to be calculated. Disposable income is the current monthly income received by the debtor, less “amounts reasonably necessary to be expended” for the debtor’s maintenance and support, plus any qualifying charitable contributions and business expenditures. Current monthly income is calculated by averaging the debtor’s monthly income in the six full months preceding the bankruptcy petition. The definition of “amounts reasonably necessary to be expended” is included in §1325(b)(3), and is different depending on whether the debtor has monthly income, when calculated for a year, greater than the median family income of the applicable state. This amount can vary depending on the number of individuals in the household. If the debtor has current monthly income, when calculated over 12 months, greater than the applicable state median family income, only those expenses included in Bankruptcy Code § 707(b)(2) are included as amounts reasonably necessary. If the debtor has less than the applicable median amount, all amounts for the maintenance or support of the debtor or the debtor’s dependents are included.

In the Diaz case, Ms. Diaz’s current monthly income, projected over 12 months, was less than $59,570, the median income for a family of her size in Texas in 2017. The expenses she claimed on her bankruptcy schedules totaled far less than the IRS National Standards for a family of the same size. The Fifth Circuit concluded that “[W]e find it entirely plausible that Debtor will use her ‘excess’ tax refund of $1,261 for expenses that are reasonably necessary for her family’s maintenance and support.” Because the standard form required Ms. Diaz to turn over the tax refund in excess of $2,000 without determining whether the excess was an amount reasonably necessary to be expended, it violated her substantive right as a below-median income debtor to retain any refund reasonably necessary to be expended for her family’s support.

Although reaching the correct decision under the Bankruptcy Code, the Fifth Circuit failed to consider whether the refund was generated by the EITC and, if so, whether that fact should be considered in determining whether a debtor should be required to include these funds. The earned income tax credit was enacted in part to provide relief for low-income families. Hopefully, the provisions of Bankruptcy Code § 1325(b)(1)(B) expanding the amounts that can be considered to be amounts reasonably necessary to be expended for the maintenance and support of families with incomes below the median income of the state will be sufficient to continue to protect the relief Congress granted to low-income families through the EITC provisions. However, the fact that Ms. Diaz was required to appeal her case to the Fifth Circuit in order to protect her rights argues for an opinion that more explicitly recognizes the purposes of the EITC.

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