Court Rules that Tax Overpayment Belongs to Bankruptcy Estate

Many taxpayers overpay their tax obligation and have a right to a refund of those overpayments when they file their tax return. Another option in such a situation is to have the amount of the overpayment apply to future tax liability. What is the best strategy? Well, that depends - and bankruptcy filing may complicate matters. That’s what this case is all about.

Here, the taxpayers overpaid their 2001 state and federal tax liability and were entitled to refunds of the overpaid amounts.  Instead of requesting a refund, however, the taxpayers elected to apply the overpayments to their future tax liability. That meant that the overpaid amounts were essentially on deposit with the federal and state government to be applied against future tax liability. Sixteen days later, the taxpayers filed for bankruptcy. The bankruptcy trustee claimed that the overpayments should be included in the bankruptcy estate, but the taxpayers disagreed. Indeed, the taxpayers applied the 2001 overpayments to their 2002 tax liability.  

The Bankruptcy Court held that the overpayment was an asset of the bankruptcy estate. That meant that the taxpayers had to deliver an amount equal to the tax overpayment to the bankruptcy trustee. The taxpayers appealed, arguing the funds couldn’t possibly be part of the bankruptcy estate because their election to apply the overpayment to future tax liability was irrevocable (i.e., they couldn’t get the funds back from the IRS) and, therefore, the bankruptcy estate didn’t have any right to the funds. But, the court disagreed, reasoning that the election gave the taxpayers a credit with the government that provided a dollar-for-dollar tax reduction in the following year.  If the taxpayers had not elected to prepay their taxes, those funds would have been refunded to them and would likely have been available for the bankruptcy estate when they voluntarily filed for bankruptcy. The fact that the election was irrevocable did not change the analysis. The court noted that the term “property,” as used in the Bankruptcy Code, had been defined very broadly by the courts. Thus, the tax overpayment constituted a credit toward future taxes and was property of the bankruptcy estate at the time of the bankruptcy filing.

So, what’s the best strategy in such a situation? Get the refund in hand, spend it on exempt assets (e.g., fix up the personal residence or tools of the trade) and then file for bankruptcy. Nichols v. Birdsell, No. 05-15554, 2007 U.S. App. LEXIS 10919 (9th Cir. May 9, 2007).