By: Donald L Swanson

Taxpayers can elect to have their tax refunds applied to pay their next year’s taxes.

But a taxpayer in (or about to be in ) bankruptcy had better beware—doing such a thing might (or might not) result in a discharge denial.  

Illustrating the issue is a recent opinion in Miller v. Wylie (In re Wylie), Adv. No. 21-4012 in Eastern Michigan Bankruptcy Court (April 17, 2023; Doc. 124).

In Wylie, Debtors are denied their Chapter 7 discharge under § 727(a)(2)(B)[fn. 1]), because of false bankruptcy disclosures about their tax refund elections.  Notably:

• false bankruptcy disclosures about 2018 tax returns are not a problem; but
• false bankruptcy disclosures about 2019 tax returns result in discharge denial.

I’ll try to explain.

Background

Here’s what happened.

–2018 tax returns

Five months before filing Chapter 7 bankruptcy, Debtors file their 2018 joint tax returns claiming refunds totaling $39,273: $21,317 from the IRS, and $17,956 from the State.

On their 2018 tax returns, Debtors elect to apply all tax refunds to their 2019 income tax liabilities.

Debtors’ Chapter 7 Trustee alleges that such elections are grounds for denying Debtors’ discharge under § 727(a)(2)(A), because they:

• “transferred” and “concealed” their property;
• “with intent to hinder, delay, or defraud a creditor”;
• “within one year before the date of the filing of the [Chapter 7] petition.”

–2019 tax returns

Three weeks after filing Chapter 7 bankruptcy, Debtors file their 2019 joint tax returns, showing credits for the 2018 refunds and claiming refunds totaling $41,534: $20,798 from the IRS, and $20,736 from the State.

On their 2019 tax returns, Debtors elect to apply all tax refunds to their 2020 income tax liabilities.

Debtors’ Chapter 7 Trustee alleges that such elections are grounds for denying Debtor their discharge under § 727(a)(2)(B), for the same reasons as the 2018 refunds, except that these elections occurred “after the date of the filing of the [Chapter 7] petition.”

–2020 tax returns

Debtors file their 2020 income tax returns with refunds in amounts higher than the 2018 and 2019 tax refund amounts. However, they elect to receive the 2020 tax refunds promptly, rather than trying to apply them to 2021 taxes.

Then, long-story-short, Debtors’ Chapter 7 Trustee receives Debtors’ 2020 tax refunds.

–Disclosures in Bankruptcy

Item 28 on Debtors’ bankruptcy Schedules requires disclosure of tax refund information. On Item 28, Debtors disclose tax refunds owed to them, (i) in “Unknown” amounts, and (ii) estimated to equal Debtors’ tax liability amounts.

Both Debtors sign and file their Schedules under penalty of perjury.

–Chapter 7 Trustee’s Allegations

Debtors’ Chapter 7 Trustee files a Complaint to deny both Debtors’ discharge, alleging these false statements by Debtors:

• failing to disclose their tax overpayments for 2018 and 2019;
• falsely declaring that tax refund amounts are “unknown”;
• falsely declaring that the tax refund amounts are “estimated to equal the tax liability”; and
• repeating the false statements under oath at the § 341 meeting, by testifying that their Schedules are “truthful, accurate, and complete.”

Bankruptcy Court Discussion

–General Principles of Discharge Law

The Bankruptcy Court identifies these “general principles” for bankruptcy discharge denial:

• section 727(a) contains twelve enumerated grounds for denying a debtor’s discharge;
• all elements for each ground are to be narrowly construed and established by a preponderance of the evidence, to protect the debtor’s fresh start; but
• those who seek bankruptcy protection must not play fast and loose with their assets or with the reality of their financial affairs.

–2018 Tax Returns = No Discharge Problem

Debtors’ elections to apply their 2018 tax overpayments to their 2019 tax liabilities do qualify as pre-petition “transfers” that “concealed” Debtors’ property, under §727(a)(2)(A).

However, such transfers and concealments do not create a discharge problem for Debtors under §727(a)(2)(A).  That’s because Debtors’ 2018 tax refund elections are not made “with intent to hinder, delay, or defraud.”

Here’s why not.  When Debtors elect to apply their 2018 tax refunds to the next year’s tax liabilities:

• there is no Chapter 7 Trustee in place;
• Debtors’ bankruptcy case is not yet filed—and won’t be filed for another five months; and
• there is no evidence of an intent to hinder, delay, or defraud any creditor or trustee in a bankruptcy case that is not yet filed.

Instead, the evidence shows that Debtors made their 2018 tax refund elections with the sole purpose of insuring payment of their 2019 tax liabilities.  Such a pre-bankruptcy purpose does not qualify as an intent “to hinder, delay, or defraud” within the meaning of §727(a)(2)(A).

Debtors did make false bankruptcy statements, (i) in declaring the 2018 tax refund amounts to be “Unknown,” and (ii) swearing that disclosures on their Schedules are true and accurate.

But mere falsehood is not enough to deny a debtor’s discharge.  The Trustee must also prove the falsehoods are made “with fraudulent intent.’

In this case, Debtors did not have a fraudulent intent in making the “Unknown” statements under oath because:

• Debtors’ tax returns show the exact amount of Debtors’ tax overpayments;
• When Debtors make the false statements, they and their attorney know that Debtors’ 2018 and 2019 tax returns will need to be provided to the Trustee; and
• So, Debtors cannot possibly have intended to deceive or mislead the Trustee by the false statements.

Accordingly, the Trustee’s objection to discharge under §727(a)(4)(A) fails for the 2018 tax return elections.

–2019 Tax Returns = Discharge Denied

Debtors make post-petition “transfers” of property of the bankruptcy estate, when they elect to apply their 2019 tax overpayments to their 2020 tax liabilities. This happens three weeks after filing bankruptcy, when the 2019 tax refunds are clearly property of Debtors’ bankruptcy estate.

Further, such an election is a transfer of property of the bankruptcy estate “with intent to hinder, delay, or defraud” the Trustee and/or creditors.

Accordingly, Debtors must be denied a discharge under 11 U.S.C. §727(a)(2)(B).

Here are Bankruptcy Court findings:

• Had Debtors elected to receive their 2019 tax overpayments as refunds, the taxing authorities would have promptly paid the tax refunds;
• Instead, the refunds were not paid until much later—creating the potential for litigation by the trustee to avoid the 2019 tax refund transfers, as unauthorized post-petition transfers; and
• Though the Chapter 7 Trustee would have prevailed, such litigation would have been costly and cause delay.

As things turn out, such litigation was not necessary because Debtors filed their 2020 income tax returns electing to receive the 2020 tax refunds (in amounts greater than in 2018 and 2019) and pay those refunds over to their Chapter 7 Trustee.

Additionally, there is another twist: exemption claims.

Exemption Claims

Meanwhile, Debtors amend their bankruptcy exemption claims to include the entire tax refunds as exempt.

Debtors’ Chapter 7 Trustee objects to the amended exemption claims, the Bankruptcy Court sustains the Trustee’s objection, and the U.S. District Court affirms on appeal.

So, while Debtors and Trustee are litigating the exemption issue, the Trustee cannot obtain the tax refunds.  But in the end, the Trustee does obtain possession of the tax refunds.

Intent Issue

Debtors’ Chapter 7 Trustee was not actually hindered or delayed—but that’s not dispositive of the discharge denial issue.

Instead, it is Debtors’ intent in making their 2019 tax refund elections that matters.

Under §727(a)(2) there is no requirement of “proof of harm,” or that creditors or the Trustee “must have, in fact, been hindered, delayed or defrauded.” 

Ruling

Accordingly, the Bankruptcy Court finds that Debtors did intend to hinder the Trustee in making their post-petition 2019 tax refund elections:

• Both Debtors admit at trial that the purpose of their 2019 tax elections was to assure that their 2020 taxes would be paid.

Such a purpose is to prefer Debtors’ taxing authority creditors over other creditors.  And in Debtors’ post-petition context, such a purpose “is at war with”:

• the priority and distribution scheme of the Bankruptcy Code; and
• the Trustee’s duty under 11 U.S.C. § 704 to follow that scheme.

In other words, Debtors intended, at a minimum, to hinder the Trustee:

• whether Debtors were familiar with the Bankruptcy Code’s distribution scheme, or not, Debtors’ actual intent to prefer tax creditors is, nevertheless, an intent to “hinder” the Trustee. 

Accordingly:

• in making their 2019 tax elections, Debtors transferred property of the bankruptcy estate with intent to hinder the Trustee; and
• under the provisions of §727(b)(2)(B), the Bankruptcy Court must deny each of the Debtors a discharge.

Conclusion

Taxpayers can elect to have their tax refunds applied to pay their next year’s taxes. 

But they had better beware, when a bankruptcy is involved, because doing such a thing might (or might not) result in a discharge denial.  

———————-

Footnote 1.  11 U.S.C. § 727(a)(2)(A)&(B) say:

“(a)The court shall grant the debtor a discharge, unless— . . . (2) the debtor, with intent to hinder, delay, or defraud a creditor or an officer of the estate charged with custody of property under this title, has transferred, removed, destroyed, mutilated, or concealed, or has permitted to be transferred, removed, destroyed, mutilated, or concealed—(A) property of the debtor, within one year before the date of the filing of the petition; or (B) property of the estate, after the date of the filing of the petition.

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