Tax credits in bankruptcy

Editor: Valrie Chambers, CPA, Ph.D.

Tax issues can arise in the bankruptcy context. One of those issues is the retention of amounts attributable to tax credits and refunds. As a general matter, tax refunds and credits are normally the property of the bankruptcy estate. In Segal v. Rochelle, 382 U.S. 375 (1966), for example, the Supreme Court held that loss-carryback refund claims were property of the bankruptcy estate because they were “sufficiently rooted in the pre-bankruptcy past and so little entangled with the bankrupts’ ability to make an unencumbered fresh start” (id. at 380). Similarly, the Supreme Court held in Kokoszka v. Belford, 417 U.S. 642 (1974), that tax refunds (based on prepetition tax years or portions thereof) were included in property of the bankruptcy estate, too.

When a consumer bankruptcy petition is filed, a bankruptcy estate is created that consists of, among other things, “all legal or equitable interests of the debtor in property as of the commencement of the case” (11 U.S.C. §541(a)(1)). Certain property, however, is exempt for public policy reasons, meaning that the debtor can keep it. States may either use the federal bankruptcy exemptions or create their own. From the federal list of exemptions, a potentially relevant exemption for certain tax credits is contained in 11 U.S.C. Section 522(d)(10)(A), which exempts a “debtor’s right to receive . . . a social security benefit, unemployment compensation, or a local public assistance benefit.” Often there is a similar exemption in state law, too.

Thus, since tax refunds and refunds attributable to tax credits can come into the bankruptcy estate, the critical issue is whether an exemption applies to those amounts. A key exemption is for public-assistance benefits. A recent case, In re Manuel, No. 17-60450 (Bankr. S.D. Ill. 10/2/18), addressed this issue in particular — that is, whether a specific tax credit, the nonrefundable child tax credit, may be exempt.

The issue in In re Manuel was whether the nonrefundable child tax credit qualified as a “public assistance benefit,” as defined by Illinois law, so that it would be exempt under the specific Illinois exemption. The bankruptcy court concluded that a nonrefundable child tax credit was not exempt under Illinois law as a public-assistance benefit. The court agreed with prior cases that focused the analysis on whether the credit at issue was refundable because a nonrefundable tax credit results in only a refund of funds that the taxpayer had previously paid, whereas a refundable tax credit pays out general government revenues. Stated otherwise, “public” assistance connotes a use of government funds or resources, so a return of the taxpayer’s previously paid funds is not a use of government funds or resources.

Also, the court reasoned that a public-assistance benefit, by its very terms, must be “intended to provide relief to low income individuals and families.” Because the child tax credit also provides relief to middle- and upper-income families (subject to phaseouts, of course), it could not be a public-assistance benefit.

Whether a bankruptcy exemption applies depends on the tax credit at issue and the underlying state or federal exemption. For example, the Eighth Circuit in In re Hardy, 787 F.3d 1189 (8th Cir. 2015), held that the additional child tax credit (ACTC) — which is refundable, unlike the credit discussed in In re Manuel — did constitute “public assistance benefits” under Missouri law. The court based its holding on the amendments to the ACTC since its enactment. As originally enacted, the child tax credit (CTC) allowed a nonrefundable credit of $500 per qualifying child. The child tax credit has, of course, been modified since then. These modifications and amendments, the court concluded, show that “the intent of the legislature when modifying the ACTC was to benefit low-income families” (In re Hardy, 787 F.3d at 1196).

Similarly, some bankruptcy courts have held that the federal earned income tax credit (EITC) constitutes a public-assistance benefit under state law. However, in other states, that may not necessarily be the case. For instance, in In re Rutter, 204 B.R. 57 (Bankr. D. Or. 1997), a bankruptcy court held that EITC payments were not public-assistance benefits under Oregon law because they were not paid under state law, i.e., the definition of those benefits under Oregon law at that time was more restrictive. Cases have examined whether other credits constitute public-assistance benefits; for example, a bankruptcy court in In re Arthur, No. 10-00463-als7 (Bankr. S.D. Iowa 10/20/10), held that the Hope scholarship credit did not constitute a public-assistance benefit under Iowa law.

Whether and to what extent a taxpayer may keep a tax refund or credit in bankruptcy is an important intersection of tax and bankruptcy law. As the cases show, this is a function of the particular tax credit and particular exemption at issue.