Can the Government Take My Tax Refund If I File Bankruptcy?

It is not uncommon for the state government to intercept and keep tax refunds for a current year as a method of offsetting unpaid past debts.  But what happens to the refunds if the taxpayer files bankruptcy before the government intercepts the refunds?  That issue was addressed in In re Johnson, 521 B.R. 912 (Bankr. W.D.AR. 2014).

In Johnson, the taxpayer anticipated receiving a tax refund from the IRS at some point after the bankruptcy case was filed.  The taxpayer listed the anticipated tax refund as an asset on the bankruptcy schedules with a corresponding exemption. The taxpayer owed money to the Arkansas Department of Workforce Services (“Government”) on the day the bankruptcy case was filed,  but failed to list the Government as a creditor holding a potential fraud claim.  Later, the Chapter 7 trustee entered a “no-asset” report indicating there were no assets for distribution to any unsecured creditors.  Ultimately, the court entered a discharge order.

The Government intercepted the tax return after the bankruptcy discharge had been entered, and refused to return the refund to the taxpayer.  The taxpayer responded by filing with the bankruptcy court a motion for contempt for violating the discharge injunction of 11 U.S.C. §524(a)(2).  Taxpayer argued that the Government was duty-bound to return the refund and later file an adversary to determine whether the Government’s debt was discharged. The Government opposed the motion for contempt and argued that the Government should have been notified of the bankruptcy filing and the lack of notice caused the debt to be rendered nondischargeable.

The Johnson court noted three key facts: (1) the Government had never received notice of the bankruptcy case before intercepting the refund; (2) the trustee had issued a “no-asset” report; and (3) the Government’s claim was based in fraud.  These facts triggered the applicability of 11 U.S.C. §523(a)(3)(B), which allows litigation to proceed at any time on the issue of fraud.  A creditor holding a fraud claim which was not notified of the bankruptcy filing is not restrained by the typical 60-day objection period of Bankruptcy Rule 4007(c).

Moreover, the Johnson court ruled that the bankruptcy court no longer had exclusive jurisdiction over the determination of dischargeability under §523(a)(2), (4) or (6).  Instead, the bankruptcy court shares jurisdiction with the state court. In short, the penalty to the taxpayer for failing to schedule the creditor holding a fraud claim is forfeiture of the right to enjoy exclusive federal jurisdiction and loss of the 60-day limitations period applicable in exclusive jurisdiction actions.

In short, the Johnson court rejected the taxpayer’s attempt to hold the Government in contempt for violating the discharge injunction.  Similarly, the court rejected the Government’s argument that the debt was rendered nondischargeable.  Instead, the court denied the motion for contempt and declined to hold the Government in contempt until a court of competent jurisdiction rendered a judgment on whether the Government’s claim for fraud was rendered dischargeable or nondischargeable by the bankruptcy discharge.

Practice Pointer:   Taxpayers should strive to list accurately all creditors by name and address. Taxpayers who fail to give a creditor proper notice could find those debts nondischargeable in a Chapter 13 case or an “asset” Chapter 7 case.  But, if a taxpayer discovers that a creditor holding a potential fraud claim was inadvertently omitted from an “no-asset” Chapter 7 bankruptcy case, then the taxpayer should file an adversary proceeding in the bankruptcy court seeking a determination that the claim was discharged by the bankruptcy.

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

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