Can a Taxpayer Keep an IRS Tax Refund Received Shortly Before Filing Bankruptcy?

An Illinois taxpayer received a $10,000 refund about a month before filing bankruptcy.  The taxpayer identified the tax refund in amended Schedule B as “2013 Tax Refund (Earned Income Credit) -$4,989.00; 2013 Tax Income Refund (Child Care Credit)-$3,000.”

The taxpayer sought to keep that money and protect it from seizure by the Chapter 7 trustee.  The trustee wanted to include the tax refund as a non-exempt asset that should be added to the “bankruptcy estate.” The taxpayer attempted to exempt the tax refund from the bankruptcy estate by claiming it was “public assistance benefits” protected under the Illinois exemption statute 735 ILCS 5/12-1001(g)(1).  The trustee did not object to the taxpayer’s characterization of the tax refund as “public assistance benefits.”  But, the trustee objected because the taxpayer received the refund before the bankruptcy filing date, and argued that the Illinois exemption statute cited by the taxpayer did not apply.

The court resolved the issue by sustaining the trustee’s objection to the taxpayer’s claimed exemption, thus causing the tax refund to become property of the bankruptcy estate for redistribution to the unsecured creditors.  In re Frueh, 518 B.R. 881 (Bankr. N.D.IL 2014)(Lynch, J).  The court made a distinction between a taxpayer’s Section 5/12-1001(g)(1) “right to receive…public assistance benefits” in the future and a taxpayer’s Section 5/12-101(h) “right to receive, or property that is traceable to…” an asset.  The Frueh court’s distinction clarified the Illinois legislature’s desire to exempt public assistance benefits to be received in the future and not public assistance benefits already received. The court noted that the legislature knew how to protect already received assets when it wanted to do so (citing Section 5/12-101(h)), and chose not to protect public assistance benefits already received.

Practice Pointer:  A taxpayer anticipating a tax refund relating to the Earned Income Credit and/or the Child Care Credit should file a Chapter 7 bankruptcy case PRIOR to filing the IRS tax return— to ensure the tax refund would be received AFTER the case filing.  If needed, a taxpayer could request from the IRS an automatic extension to the tax return filing deadline to ensure the refund would be received after the bankruptcy case was filed.  To do otherwise results in the loss of the tax refund to the Chapter 7 trustee for re-distribution to the bankruptcy creditors.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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