Election to Apply Tax Refund to Next Year's Taxes Did Not Bar Bankruptcy Discharge

(Parker Tax Publishing May 2023)

A bankruptcy court held that taxpayers who elected, five months before filing their Chapter 7 bankruptcy petition, to apply their joint tax refund for 2018 to their 2019 tax liability did not transfer or conceal property with the intent to hinder, delay, or defraud a creditor under 11 U.S.C. Section 727(a)(2)(A), and therefore rejected the trustee's motion for denial of their discharge on that basis. However, the court denied discharge under 11 U.S.C. Section 727(a)(2)(B) after finding that the taxpayers' election to apply their 2019 refund to their 2020 tax liability, which they made after filing for bankruptcy, was a transfer made with the intent to hinder the trustee. In re Wylie, 2023 PTC 94 (Bank. E.D. Mich. 2023).

Background

Leah and Jason Wylie filed a joint Chapter 7 bankruptcy petition in August 2020. The Wylies began having serious financial problems as early as August 2018. Jason suffered severe health problems beginning in 2014, when he had surgery to remove a brain tumor. He had surgeries again in 2017 and 2018. Before his health problems began, Jason worked full time as an engineer for General Motors and earned additional income from farming. He also owned two small businesses. By August 2018, Jason could no longer work due to his continuing health problems.

In his farming work and businesses, Jason had a significant amount of farm machinery

and equipment and vehicles, which had been financed with secured lenders. After Jason became unable to work, the Wylies experienced large financial losses. Several vehicles and all of the farm machinery and equipment was repossessed. The Wylies stopped paying their credit card bills in late 2018. In 2019, the Wylies were parties to at least four lawsuits filed by creditors, as well as repossessions and numerous garnishments by creditors.

The Wylies filed their 2018 federal and state tax returns in March 2020 - almost five months before filing for bankruptcy. The Wylies' 2018 state and federal income tax returns showed that the Wylies had overpaid their federal tax by $21,317 and their Michigan income tax by $17,956. Out of concern that they might have significant income tax liabilities for 2019, the Wylies elected to have these overpayments applied to their 2019 income tax liabilities. In September 2020, just under three weeks after filing their bankruptcy petition, the Wylies filed their joint 2019 federal income tax return. Their 2019 federal tax return reflected an overpayment of $20,798, while their state tax return showed an overpayment of $20,736. The Wylies elected to have their federal state overpayments applied to their 2020 tax liabilities, rather than receive refunds.

Under 11 U.S.C. Section 727(a)(2)(A), a debtor in a bankruptcy is entitled to receive a discharge unless the debtor, with intent to hinder, delay, or defraud a creditor or the trustee, transfers or conceals property of the debtors within one year before the date of filing the bankruptcy petition. Under 11 U.S.C. Section 727(a)(2)(B), the same discharge prohibition applies with respect to property of the estate which is transferred or concealed after the filing of the petition.

The trustee for the Wylies' bankruptcy filed a motion seeking to deny the Wylies a discharge, arguing that their elections to carry forward their tax 20018 and 2019 tax refunds violated 11 U.S.C. Section 727(a)(2) because the elections were transfers made by the Wylies with the intent to hinder the trustee.

Analysis

The bankruptcy court found for the Wylies with respect to their pre-petition election to apply their 2018 tax refunds to their 2019 tax liabilities. However, the court sided with the trustee as to the Wylies' 2019 tax refunds and denied a discharge under 11 U.S.C. Section 727(b)(2)(B).

The court found that the trustee's objection to discharge under 11 U.S.C. Section 727(a)(2)(A) failed because he did not prove that the Wylies' 2018 tax refund transfers were made with the intent to hinder, delay, or defraud a creditor or the trustee. In the court's view, the Wylies' 2018 refund transfers were made with the sole intent of trying to insure that there would be enough money for them to pay their 2019 federal and state income taxes. Such intent, the court found, did amount to an intent to give preferential treatment to IRS and the Michigan Department of Revenue compared to the treatment of other creditors.

The court found that, as a matter of law, a debtor's mere intent to prefer one creditor over other creditors cannot be deemed an intent to hinder, delay, or defraud a creditor or creditors within the meaning of 11 U.S.C. Section 727(a)(2)(A). Construing the Section 727(a)(2)(A) intent element in this way, the court found, would be inconsistent with the requirement that the Section 727(a) grounds for denying discharge be narrowly construed in furtherance of the Bankruptcy Code's fresh start policy. The court said that if in making a pre-petition transfer, a debtor's mere intent to prefer one creditor over others were sufficient to deny discharge, that could subject most or all debtors who merely make a pre-petition preferential transfer to a denial of their discharge.

However, the court agreed with the trustee that the Wylies' post-petition election to apply their 2019 refunds to their 2020 tax liabilities were transfers made with the intent to hinder the trustee under 11 U.S.C. Section 727(a)(2)(B). The court noted that the focus of this analysis was on the debtors' intent rather than the actual effect of their actions. The court explained that the trustee was not actually hindered or delayed in getting the tax refunds belonging to the bankruptcy estate, since the Wylies' 2019 refunds were still intact when they filed their 2020 income tax returns and elected to receive refunds, which they unsuccessfully argued were exempt in an earlier adversary proceeding.

The court found that the Wylies did intend to hinder the trustee in making their 2019 refund elections, because they both admitted in their trial testimony that they were trying to try to make sure that their 2020 taxes would be paid. As with the same election they made for their 2018 tax refunds, the court said that the Wylies' purpose was to prefer their two taxing authority creditors over their other creditors. The court found that, in the post-petition context, the Wylies making a transfer of estate property with this purpose was wholly inconsistent with the duties of the Chapter 7 trustee.

The Chapter 7 trustee, the court explained, could not give the Wylies' intended preferential treatment to these taxing authority creditors for 2020 taxes for three reasons. First, because the Wylies filed their bankruptcy case mid-year, in August 2020, only some of their 2020 tax liabilities even arguably accrued pre-petition, and the rest accrued post-petition. The entire 2020 income tax liability could not be paid by the trustee in the Chapter 7 case; at a minimum, the post-petition portion of the 2020 taxes could not be deemed an allowed claim in the bankruptcy case, and for that reason could not be paid. Second, even if all of the Wylies' 2020 income taxes could be considered as a pre-petition allowed claim, no portion of the 2020 income tax liability would be a priority claim under 11 U.S.C. Section 507(a). At most, such taxes could only be paid as non-priority unsecured claims, pro rata with all other such creditors. Third, the court said that in any event, any claim by the taxing authorities for the Wylies' 2020 income taxes would be subordinate to the payment, in full, of all allowed administrative expenses under 11 U.S.C. Sections 507(a)(2) and 726(a)(1).

Thus, the court concluded that the Wylies' intent that their 2020 income taxes be paid in full was at war with the priority and distribution scheme of the Bankruptcy Code, and with the trustee's duty to follow that scheme in administering the assets of the bankruptcy estate, including the Wylies' rights to 2019 income tax refunds, which were property of the bankruptcy estate. The court therefore entered judgment for the trustee on his objection to the discharge under 11 U.S.C. Section 727(a)(2)(B).

For a discussion of the discharge of taxes in bankruptcy, see Parker Tax ¶16,160.

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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