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Fifth Circuit Protects Chapter 13 Debtors from Forfeiting Their Tax Refunds

Last week, the Fifth Circuit in Matter of Diaz invalided a bankruptcy court rule that would have required that taxpayers make available to creditors any current or projected tax refund in excess of $2,000.  Docket No. 19-50982 (5th Cir., Aug. 26, 2020).

The perfect storm is developing for this issue to affect a growing number of taxpayers.  Due to the economic downturn during the Coronavirus pandemic, a record number of bankruptcies is anticipated.  Also expected is a potentially unprecedented number of tax refunds as a result of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which enables taxpayers to carryback net operating losses to the prior 5 tax years.  Thus many taxpayers experiencing substantial business losses in 2020 may be candidates for both bankruptcy and for tax refunds under the CARES Act.

The Matter of Diaz case involved a Chapter 13 bankruptcy.  For persons seeking protection from creditors under the Bankruptcy Code, Chapter 13 provides a mechanism for relief that is often desirable for debtors that have a regular source of income to discharge their debts after completing a bankruptcy plan.  Unlike Chapter 7 bankruptcies, the debtors in Chapter 13 bankruptcies remain substantially in control over their bankruptcy plans and may mitigate the need to liquidate assets. 

There are parameters for the Chapter 13 bankruptcy plan, however.  Relevant here, if the bankruptcy trustee or an unsecured creditor objects to the bankruptcy plan’s confirmation, the bankruptcy court may not confirm a chapter 13 plan unless “the plan provides that all of the debtor's projected disposable income to be received in the applicable commitment period ... will be applied to make payments to unsecured creditors under the plan.” Bankruptcy Code § 1325(b)(1)(B).

At issue in Matter of Diaz was whether a Chapter 13 debtor’s projected federal tax refunds must be included in the amount of “disposable income” available to creditors.  The United States Bankruptcy Court for the Western District of Texas, where the bankruptcy in Matter of Diaz was docketed, promulgated a local rule that in effect required that any tax refunds in excess of $2,000 be included in disposable income.  There are other bankruptcy courts with similar rules.  Compare, US Bankruptcy Court for the Northern District of Texas, Standing Order Concerning All Chapter 13 Cases.  Under established precedent, bankruptcy courts have authority to adopt local rules governing practice and procedure, but such rules must be procedural only—they may not “abridge, enlarge, or modify any substantive right.”

The Fifth Circuit explained that the Bankruptcy Code does not expressly address a debtor’s substantive rights to tax refunds in the Chapter 13 plan.  However, as the Fifth Circuit remarked, the Bankruptcy Code as interpreted by the Supreme Court supports that for below-median income debtors, any amounts reasonably necessary to be expended for the maintenance and support of a debtor are not to be considered in disposable income.  Accordingly, below-median income debtors should be permitted to retain any tax refunds they demonstrate are “reasonably necessary” for their maintenance and support. 

Judging the bankruptcy local rule at issue against this standard, the Fifth Circuit concluded that the “one-size-fits-all” categorical rule that tax refunds in excess of $2,000 be turned over to the Trustee, regardless of any showing the debtor might make that the tax refunds are necessary for their maintenance and support, abridges the substantive rights of below-median income debtor and is therefore invalid.  Given the anticipated rise in bankruptcy filings and tax refunds under the CARES Act, the Fifth Circuit’s decision should be welcome news to many debtors, and advances the CARE Act’s goal of increasing liquidity to pandemic-affected persons incurring substantial economic losses.

Tax attorneys at Chamberlain Hrdlicka assist interested parties and their bankruptcy attorneys on tax planning opportunities and tax liability issues in connection with bankruptcy proceedings.

Categories: COVID-19, Tax Relief