In the case of In re Lee, the U.S. District Court for the Southern District of Indiana reversed a bankruptcy court’s ruling requiring that one-half of the joint income tax refunds belonging to the debtor and his nondebtor spouse, who had not filed bankruptcy, to be turned over to the bankruptcy trustee.
Under bankruptcy law, the filing a petition for bankruptcy relief does not prevent the interception of a tax refund.
Background and procedural history
In 2012, the debtor filed an individual petition for bankruptcy relief under Chapter 7. Later that year the debtor and his spouse filed joint federal and state income tax returns for the 2011 tax year. Due to an overpayment of estimated tax, the debtors were entitled to federal and state tax refunds totaling $30,751.00 for the 2011 tax year.
The bankruptcy trustee filed proceedings for a “turnover” of the tax refunds to the bankruptcy estate. The bankruptcy court applied a 50/50 rule, dividing the refund equally between the debtor and nondebtor spouse, and ordered a turnover to the trustee of the debtor’s 50 percent share of the refunds.
The district court’s ruling
The district court noted that the courts are not all in agreement on this issue. The courts have used different methods to allocate joint tax refunds between a debtor and a nondebtor spouse.
In this case, the bankruptcy court applied the “minority approach,” also known as the 50/50 approach. This approach is based upon a court presumption under domestic relations law that spouses must share equally in a tax refund. The presumption applies unless a domestic relations court orders spouses the refund to be split in non-equal proportions or there is a valid, written prepetition agreement by the spouses to that effect. This approach does not factor in the respective amounts of income earned by each spouse, or the amount of taxes withheld for each spouse, or the amount of any exemptions or credits applicable to each spouse.
The district court rejected this approach because it believed that the proper approach must consider the amounts each spouse actually contributed toward the refund amount. The court also noted that this approach contravenes Indiana domestic relations law principles, which permit unequal ownership of property between spouses based on the percentage amount each contributed to the acquisition of the property.
A second approach that has been applied by a majority of the courts allocates joint tax refunds based on the percentage amount of respective tax withholdings of each spouse for the tax year.
Under the third approach, known as the Separate Filings Rule or the Internal Revenue Service Formula, ownership of a joint tax refund is calculated by examining what each spouse’s contributions and tax liabilities would have been if returns designated as “married filing separately” had been filed, and then assigns those percentages to the amount of the refund that was due under the jointly filed tax return.
The district court adopted this approach and reversed the bankruptcy court’s ruling. In this particular case, 100 percent of the federal tax refund resulted from overpayments by the nondebtor spouse and the court held that she was entitled to 100 percent of the refund.
Contact an attorney
Individuals facing possible bankruptcy are urged to seek the advice of a competent attorney, experienced in such matters, in order ensure that their legal rights are protected.