Refund of Withheld Social Security Income Was Exempt in Bankruptcy

(Parker Tax Publishing August 2022)

A district court overruled a trustee's objection and held that a chapter 7 debtor's refund of withholdings from his social security income was exempt social security income. The court rejected the trustee's argument that under Code Sec. 3402(p), the funds lost their character as exempt funds once they were withheld as a tax, after finding that the debtor's election to withhold funds for tax purposes did not affect the protection from general creditors provided by 42 U.S.C. Section 407. In re Weber, 2022 PTC 212 (Bankr. M.D. Fla. 2022).

Background

Jerome Weber filed a chapter 7 bankruptcy petition in February 2022. On his schedule of income, Weber stated that he receives $1,787 per month as social security income and $378 per month as wages from his employment. After filing the petition, Weber received an income tax refund of $5,536 for the 2021 tax year.

On his amended schedule of exemptions, Weber claimed $3,751 of the total refund as an exempt social security benefit. Weber asserted that he "over deposited from his social security funds an estimated tax deposit," that the IRS returned the overpayment to him as a tax refund, and that the returned overpayment was exempt because it was traceable to his social security benefit. Therefore, Weber claimed the refund as exempt under 42 U.S.C. Section 407, which generally provides that social security benefits are not subject to execution, levy, attachment, garnishment, or other legal process.

The trustee objected, asserting that under Code Sec. 3402(p), the social security benefits lost their character as exempt funds once they were withheld as a tax. Code Sec. 3402(p) provides that if a taxpayer requests that a specified federal payment (such as social security benefits) be subject to withholding for income taxes, the payment is treated as if it were a payment of wages by an employer to an employee. Thus, according to the trustee, the refund was a tax because the money was collected as a payment against a tax liability, even if it was originally withheld from social security benefits.

In In re Crutch, 2017 PTC 580 (Bankr. E.D.N.Y. 2017), a bankruptcy court held that payments withheld from social security benefits under Code Sec. 3402(p) lost their exempt status because payment of social security benefits is "considered equivalent to payment of 'wages.'" However, in In re Spolarich, 2009 PTC 461 (Bankr. N.D. Ind. 2009), a bankruptcy court reached the opposite result. In that case, a debtor elected to have funds withheld from her social security payments, the funds were returned to her as a tax refund, and the trustee in her chapter 7 case requested turnover of the refund. The court first noted that the protection provided to social security benefits by Section 407(a) is "exceptionally expansive" and only subject to modification by express statute. The court then determined that a social security recipient's request to have funds withheld from social security benefits under Code Sec. 3402(p) is limited to the specific purposes of the Internal Revenue Code. By making the withholding request, the court found, the social security recipient consents only to subjecting the money to the payment of his or her tax liabilities, not to the payment of any other claims. The court therefore held that the debtor's tax refund did not lose its character as a social security payment and was protected by 42 U.S.C. Section 407.

Analysis

The district court found the Spolarich court's analysis to be more persuasive and therefore overruled the trustee's objection. The court said it was undisputed that Weber received monthly social security benefits, that he caused a portion of the benefits to be withheld for payment of a tax liability, that the withholding resulted in an overpayment, and that Weber received a refund of the overpayment.

The court found that Weber's election to withhold funds for tax purposes did not affect the protection from general creditors provided by 42 U.S.C. Section 407. Therefore, the court concluded that Weber was entitled to claim the refund as exempt to the extent that it was traceable to his social security benefits.

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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