By: Donald L Swanson
The question in In re Pirron, Case No. 22 B 08555 (Bankry. N.D. Ill., Decided 2/18/2025), is this:
- How is a tax refund to be allocated between a bankruptcy debtor’s estate and the debtor’s spouse who does not file bankruptcy, when they file a joint tax return?
The In re Pirron opinion identifies four “competing lines of authority” on how to answer that question—but then rejects all four and applies a new (the fifth) test.
The Four “Competing Lines of Authority”
Here is the In re Pirron opinion’s explanation of each of the four “competing lines of authority.”
- The 50/50 Rule.
This rule, (i) starts with a presumption that each spouse contributes equally to the household, including nonmonetary contributions, and (ii) concludes that the joint tax refund should be apportioned equally between the spouses.
While the 50/50 rule is easy to apply, it (i) has nothing to do with rights of the spouses under state or federal laws, and (ii) produces random results that can massively (and at all times artificially) help or harm estates and creditors.
- The Income Rule.
This rule divides joint tax refunds proportionally, according to the income generated by each spouse.
While the income rule is less random than the 50/50 rule, it can still produce similarly inaccurate results. That’s because a tax refund is the difference between taxes paid and taxes owed, which may or may not correlate with income.
- The Withholding Rule.
This rule is identified as the “majority rule.” It allocates a tax refund between spouses in proportion to their respective tax withholdings during the relevant tax year.
While the withholding rule may be the most helpful, of the four rules, in the widest range of cases, it fails to account for employee choices:
- employees make tax withholding choices, which may cause taxes to be over withheld (creating a refund) or under withheld (creating a tax debt); and
- some people choose to have no funds withheld at all and make (or are supposed to make) quarterly estimated payments, instead.
- Separate Filings Rule.
This rule apportions the tax refund, based on what each spouse’s contributions and tax liabilities would have been if the spouses had filed separately.
The separate filings rule has a variety of problems, including:
- it requires new, potentially complex, calculations to artificially understand tax obligations in a hypothetical world where the debtor and his or her spouse are not married; and
- it ignores the fact that spouses file jointly to gain tax advantages—and both a debtor and the non-debtor spouse should be entitled to the same tax advantages.
The Fifth (New) Test
The In re Pirron opinion rejects all four lines of authority described above and, then, identifies and applies a new-and-different test. Here’s a summary of the opinion’s discussion of the new-and-different test and its rationale.
“My rationale starts” from these “first principles”:
- bankruptcy is not a free-for-all equity balancing act; rather,
- bankruptcy is a forum in which:
- creditors submit claims to which they are “entitled” under state or federal law; and
- such entitlements are then enforced according to the provisions of the Bankruptcy Code.
Thus, the question at issue here is one of legal entitlement. Namely, in a contest between a debtor and the non-debtor spouse over a tax refund under a joint return, who would win? If or to the extent that:
- the debtor would win, the refund is estate property and must be turned over to the Chapter 7 trustee; but
- the non-debtor spouse would win, the tax refund was never property of the bankruptcy estate and is properly retained by the non-debtor spouse.
Neither the filing of a joint return nor the filing of a bankruptcy should change the answer to the “who would win” question. That’s because:
- case law overwhelmingly establishes that overpayments by married couples are apportionable to each spouse to the extent that he or she contributed to the overpaid amount;
- filing a joint tax return does not give one spouse an interest in the income of the other;
- a loss or credit may be applied only against the income of the person who incurred the loss or credit; and
- a joint tax return does not create new property interests for either spouse in the other’s income tax overpayment.
Applying the Fifth (New) Test to the Facts of this Case
The question in this specific case is: if there were no bankruptcy and Debtor and his non-debtor spouse were fighting over the $152,356 in tax refunds, who would get those refunds?
Here, the tax year at issue is 2021, when the Debtor’s employer withheld taxes from his paycheck and paid $15,585 to the IRS and $5,198 to the Illinois Department of Revenue.
There is no evidence that Debtor’s withholdings overestimated his actual tax obligations, either alone or as part of a married couple.
Instead, the evidence shows that, had Debtor filed separately, he would have owed additional funds to the IRS for tax year 2021, and there is no reason to believe that Debtor’s actual withholding over-reflected what he, separately or as part of this couple, actually owed.
By contrast, no withholdings were made from the non-debtor spouse’s paychecks—which paychecks were in substantial amounts. Instead, the non-debtor spouse made estimated tax payments, quarterly during tax year 2021, in amounts totaling $577,630 from a separate bank account into which her paychecks were deposited.
The nature of estimated tax payments is that they are . . . estimates. And it would make sense to overestimate (to avoid arguments for a penalty, which can be punitive).
It is impossible to ignore how the estimated payments made by Debtor’s non-debtor wife created the tax refunds that the couple were entitled to for tax year 2021.
Accordingly, the non-debtor spouse is entitled to the entire $152,356 tax refund.
Conclusion
Here’s a, “Thank you,” to the Northern Illinois Bankruptcy Court for this informative In re Pirron opinion.
** If you find this article of value, please feel free to share. If you’d like to discuss, let me know.
MEDIATBANKRY 
Leave a comment