Tax Refunds: “Who Gets What?”
Although tax refund season is about over, even though the return deadline was extended to July 15, 2020, a recent decision of a bankruptcy court prompted me to include a short page on this subject.
Most of the time, tax refunds are exempt, either by virtue of being Earned Income Tax Credit or Additional Child Tax Credit (both construed to be “public assistance” exempt under state law), under Alabama’s personal property exemption statute. So the question of whether any of the refund belongs to the Bankruptcy Estate rarely comes up. But, occasionally, it will rear its’ unpleasant head and prompt the question “who gets what?”
There have traditionally been five basic methods courts have used to approach tax refunds:
The 50-50 Rule: the refund is divided equally between jointly filing taxpayers. No doubt the simplest of the rules, yet a distinctly minority view.
The Income Rule: the refund is divided proportionately based upon the respective incomes of joint filers. The problem here, however, is that often one filer has more withholding than the other. So this view is largely disfavored.
The Withholding Rule: the tax refund is apportioned based upon the amount of each filer’s withholding. This is, I believe, pretty clearly the majority view. And as I will explain further in a moment, the view I “think” the Eleventh Circuit would be most likely to approve.
The Separate Filings Rule: the refund is allocated based upon what each joint filer would have received if filing separately. While perhaps the most accurate view, this rule would also impose upon the trustee the burden of hiring an account to create “hypothetical returns.” The workload and expense render this approach would be cumbersome and expensive.
The Hybrid Approach: in In re McInerney, 609 B.R. 497 (Bankr. N.D.Ill.2019) [a very long, detailed opinion if you have the time or interest], the debtor proposed a hybrid formula which was a combination of the 50-50 Rule and the Separate Filings Rule. Again, a cumbersome and inefficient approach.
The court in McInerney ultimately decided that the most sensible, efficient and reasonable approach was the Withholding Rule. To my knowledge, the Eleventh Circuit has not directly addressed this point in a bankruptcy setting. There is a tax case out there, however, for which I don’t currently have the citation, in which the court determined how to allocate tax liability involving joint filers based upon their respective withholdings. It was a classic application of the withholding rule, but the court just didn’t call it by that name. While it takes a little bit more time and effort than the 50-50 rule, it yields, I believe, a fair result, and is the way I analyse tax refund entitlement.