New Mexico Law Doesn't Allow Debtor to Exempt EITC Refunds from Bankruptcy Estate

(Parker Tax Publishing January 2023)

A bankruptcy court held that a debtor could not exclude from her bankruptcy estate, federal and state tax refunds she used to perform necessary home repairs, even though the majority of the refunds were due to federal and state earned income tax credits (EITCs). The court concluded that the federal EITC and New Mexico Working Families Tax Credit, despite having an anti-poverty purpose, are not exempted from the claims of creditors under the New Mexico Public Assistance Act or any other New Mexico exemption other than New Mexico's $500 wildcard exemption. In re Medina, 2022 PTC 396 (Bankr. N.M. 2022).

Background

In summer 2021, Bianca Medina engaged New Mexico Financial & Family Law, P.C. ("former counsel") to help her file for Chapter 7 bankruptcy. Medina believed that her bankruptcy case was filed July 2021. However, her former counsel did not file her bankruptcy case until March 24, 2022. Based on that filing date, Medina's entire 2021 tax refunds became prepetition assets.

On her bankruptcy schedules, Medina listed an interest in her 2021 federal and state tax refunds in an "unknown" amount. She claimed exemptions in 100 percent of the tax refunds under the $500 wildcard exemption provided in New Mexico law (i.e., Statute Sections 42-10-1 to -2.2). She also claimed an exemption of $40 in a checking account under the same wildcard exemption. Medina selected the New Mexico bankruptcy exemptions, rather than the federal bankruptcy exemptions, in order to protect significant equity in her home.

Based on her tax returns, Medina was entitled to a 2021 federal tax refund of $4,845, of which $3,618 was due to the federal earned income tax credit (EITC), and a 2021 state tax refund of $1,016, of which $724 was due to New Mexico's EITC (i.e., the Working Families Tax Credit). Medina's total 2021 tax refunds were therefore $5,861. The tax preparer fees were 10 percent of the total refunds.

Medina did not receive her 2021 tax refunds until after she began her bankruptcy case, and it was unclear why the taxing authorities sent the tax refunds directly to Medina, rather than holding the refunds until they received further instruction from the Chapter 7 trustee. Both the IRS and the New Mexico Taxation and Revenue Department were listed on the mailing list in Medina's bankruptcy case and should have received notice of her bankruptcy filing.

By April 21, 2022, Medina had spent her tax refunds, primarily on home repairs such as fixing her air conditioner and hot water heater. The Trustee objected to Medina's claim of exemptions because they exceeded the $500 limit for the New Mexico wildcard exemption. The case went before a bankruptcy court.

After the Trustee failed to appear at the preliminary hearing on the claim of exemptions, the bankruptcy court initially allowed the claim of exemptions by default by an order entered that same day. The Trustee then moved to set aside the default order and the court set it aside. A final hearing on the claim of exemptions was held on November 4, 2022, at which the Trustee and Medina each represented themselves. At the final hearing, the Trustee indicated that he was not objecting to the portion of Medina's tax refunds based on the child tax credit, which was $1,500. Thus, the Trustee only objected to $4,361 of Medina's EITC tax refunds, to the extent they exceed the $500 wildcard exemption limit. The Trustee also conceded that the $40 bank account balance listed in Medina's schedules was for an account that was closed before the petition date. Thus, the Trustee objected to the exemption of $3,861 of Medina's tax refunds. Medina via her former counsel filed a response to the Trustee's objection, asserting that the EITC was not property of the estate. Medina made the following four arguments in response to the Trustee's objection: (1) she spent the tax refunds in reliance on the Court's default order, (2) she spent the tax refunds on reasonable and necessary expenses, (3) the EITC portion of the tax refunds was not property of the estate, and/or (4) the EITC portion of the tax refunds was exempt. In support of the third argument, Medina cited two cases - In re Dunckley, 452 B.R. 241 (10th Cir. B.A.P. 2011), and In re Murray, 506 B.R. 129 (B.A.P. 10th Cir. 2014).

New Mexico law protects certain property of an individual from the reach of creditors. The Chapter 7 Trustee did not contest Medina's claim under the New Mexico wildcard exemption to exempt her tax refunds up to total of $500. While several states have passed statutes that expressly exempt EITC from the reach of creditors, New Mexico is not one of them. Additionally, unlike in some other states, New Mexico does not have an exemption that applies to public assistance benefits generally. The only New Mexico exemption is for public assistance paid or payable under the New Mexico Public Assistance Act.

Analysis

The New Mexico Bankruptcy Court held that none of Medina's arguments were a successful defense to the Trustee's objection. First, the court held that, despite its anti-poverty purpose, Congress has not enacted exemptions for EITC refunds similar to the protections available for social security and veterans' benefits.

Second, with respect to the cases cited by Medina, the court cited another Tenth Circuit opinion, In re Montgomery, 224 F.3d 1193 (10th Cir. 2000), in concluding that the Tenth Circuit has expressly held that a debtor's EITC - pro-rated to the date of filing of the bankruptcy petition - is property of the estate. In both Dunkley and Murray, the court said, the Tenth Circuit Bankruptcy Appellate Panel analyzed state exemptions that exempt EITC. At issue in Dunkley was a Colorado statute exempting the "full amount of any federal or state income tax refund attributed to an earned income tax credit or a child tax credit." At issue in Murray was a Kansas exemption allowing a debtor in bankruptcy to exempt federal and Kansas EITCs for one tax year. The court rejected Medina's reliance on these cases because, the court observed, New Mexico does not have an equivalent exemption for EITC and thus those cases did not apply to Medina's situation.

The court also stated that, while it agreed with cases holding that EITC tax funds are public assistance within the meaning of the state exemptions applicable to public assistance grants generally, New Mexico does not have such a broad public assistance exemption. The closest thing in New Mexico, the court observed, is the exemption under New Mexico's Public Assistance Act. But, the court noted, the New Mexico Public Assistance Act only exempts "money paid or payable under this act" and it does not exempt the federal or New Mexico EITC. Thus, the court concluded that the federal EITC and New Mexico Working Families Tax Credit, despite having an anti-poverty purpose, are not exempted from the claims of creditors under the New Mexico Public Assistance Act or any other New Mexico exemption other than New Mexico's $500 wildcard exemption.

Finally, with respect to Medina's claim that the tax refunds were spent in reliance on the court's default order, the court said that a review of Medina's bank records showed that all of the tax refunds were spent well before the default order was entered.

For a discussion of claiming an exemption from the bankruptcy estate for a tax refund, see Parker Tax ¶16,165.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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