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Exempting the Earned Income Tax Credit from the Bankruptcy Estate

Posted on Jan. 11, 2023

In In re Medina, No. 22-10233 (Bankr. D. N.M 2022) the bankruptcy court held that the portion of the debtor’s refund attributable to the earned income tax credit (EITC) was not exempt from the debtor’s bankruptcy estate.  The case points out a split in the outcome for debtors.  This split is not based upon a split in the interpretation of bankruptcy law but a split in how states approach exemptions.  Guest blogger Phil Rosenkrantz wrote about this several years ago in a post regarding the child tax credit.

The bankruptcy code allows each state to decide which assets a debtor may choose to exempt from the bankruptcy estate.  Most states have exempted EITC refunds because the payments meet the state definition of payment for the welfare of the individual.  Similarly, most states have exempted the advanced child tax credit (ACTC); however, each state statute stands on its own.  Ms. Medina finds out to her sorrow that New Mexico has not drafted its statutory exemptions in a manner allowing for the exemption of the EITC.  As discussed below, this is an area where Congress should step in.  We should not require a state by state determination of whether to exempt federal anti-poverty payments.

Ms. Medina filed her bankruptcy petition on March 24, 2022, making her 2021 refund a pre-petition asset. As she filed she claimed an exemption of her federal and state tax refunds for 2021 using New Mexico’s wildcard exemption which is capped at $500. She chose to use the New Mexico exemptions rather than the federal exemptions provided in BC 522 because she wanted to protect the equity in her home and New Mexico, like most states with a Spanish rather than English colonial heritage, has a generous homestead exemption.

The wildcard exemption did not provide enough protection for her 2021 refunds:

Based on her filed tax returns, Ms. Medina was entitled to a 2021 federal tax refund of $4,845 — out of which $3,618 was due to the federal EITC — and a 2021 state tax refund of $1,016 — out of which $724 was due to New Mexico’s EITC (the Working Families Tax Credit). Ms. Medina’s total 2021 tax refunds were therefore $5,861. The tax preparer fees were 10% of the total refunds.

She did not receive the refunds until after filing her bankruptcy petition – though that fact is not legally significant. She spent the refunds by April 21, 2022, making “important home repairs such as repairing her air conditioner and hot water heater.” The trustee objected to exemption of the portion of her refund that exceeded the wildcard amount except that the trustee did not object to the portion of her refund based on the Child Tax Credit (CTC).

In most fights interpreting state law, the EITC has fared better than CTC because CTC is not exclusively an anti-poverty provision. Taxpayer eligible for the CTC include middle class households as well as households falling into the poverty guidelines of most states. Usually, the ACTC has a better chance than the CTC of exemption from the estate because of the most restrictive requirements for ACTC. The trustee’s concession on CTC surprised me.

Although represented at the outset of the case, Ms. Medina was pro se at the time of the fight over the exemptions. She raised four arguments but only the argument regarding the ability to exempt the EITC portions of the refund bears discussion.

The court describes the EITC and its anti-poverty purpose but ends the descriptive section by stating:

Despite its anti-poverty purpose, Congress has not enacted exemptions for EITC refunds similar to the protections for Social Security benefits under 42 U.S.C. §407 and veterans’ benefits under 38 U.S.C. §5301(a).

That statement might serve as a basis for seeking a change in the bankruptcy law to provide protection for the anti-poverty payments administered under the IRC. These payments represent a significant portion of the federal anti-poverty payments. They should be recognized with the other payments mentioned by the court without the requirement to litigate this issue state by state.

The court notes that many states have passed legislation exempting EITC from the reach of creditors, some states have broad exemptions for public assistance benefits generally and many courts have interpreted EITC to meet the exemptions for public assistance. The case contains good citations for state laws and court decisions on this subject. The court did a nice job of researching state law and case law in a pro se case where her submissions would have left big gaps in this research. See it below in bonus material.

While the court finds that EITC payments are public assistance payments, it finds that New Mexico lacks a broad public assistance exemption. It carefully analyzes the state statute and then notes that

Other courts have similarly held that an exemption under a public assistance act does not apply to EITC tax refunds where the exemption is limited to public assistance granted under the act because EITC tax refunds are granted under federal and state tax codes. In Nevada, the bankruptcy court held that the Nevada exemption for “assistance awarded pursuant to the provisions of this chapter,” which referred to chapter 422 of the Nevada Revised Statutes, did not include EITC because it was “not paid or payable pursuant to a state-administered public welfare program under Chapter 422.” In re Thompson, 336 B.R. 800, 802 (Bankr. D. Nev. 2005). Similarly, in Arizona, the bankruptcy court concluded that the Arizona exemption for “assistance granted under this title” and “money paid or payable under this title” did not include EITC, because EITC is granted by the federal tax code, not by Arizona’s public assistance statute. In re Builder, 368 B.R. 10, 11-12 (Bankr. D. Ariz. 2007).

So, Ms. Medina cannot exempt the EITC portion of her state or federal refunds, except to the extent of the $500 wildcard exemption, which were the largest portions of those refunds. The court finds that spending the refunds for necessary expenses does not exempt them. The court does not say what she must do now that she now longer has the money. If she cannot repay the money to the estate, I expect that her bankruptcy will be dismissed without her receipt of the discharge of debts she sought in filing. This is a tough result for her but not one for which the court should be blamed.

Bonus material

For those interested, I copy below the court’s research on the state of the exemption of EITC from both a state law and case law perspective.

State law:

Several states have passed statutes that expressly exempt EITC from the reach of creditors, including Colorado, Indiana, Kansas, Louisiana, Mississippi, Nebraska, and Oklahoma.5 New Mexico has not done so.

5Colorado: Colo. Rev. Stat. Ann. §13-54-102(1)(o) (exempting full amount of any federal or state income tax refund “attributed to an earned income tax credit”); Indiana: Ind. Code Ann. §34-55-10-2(c)(11) (exempting interest in a refund or credit “received or to be received” under federal and Indiana EITC provisions); Kansas: Kan. Stat. Ann §60-2315 (exempting “right to receive” federal and Kansas EITC); Louisiana: La. Rev. Stat. Ann. §13:3881(A)(6) (exempting federal EITC “except for seizure by the Department of Revenue or arrears in child support payments”); Mississippi: Miss. Code Ann. §85-3-1(i) (exempting an amount not to exceed $5,000 of “earned income tax credit proceeds”); Nebraska: Neb. Rev. Stat. Ann. §25-1553 (exempting “full amount of any federal or state earned income tax credit refund”); Oklahoma: Okla. Stat. Ann. tit. 31, §1(A)(23) (exempting “[a]ny amount received pursuant to the federal earned income tax credit”).

Case law:

Many courts hold that EITC tax funds are public assistance within the meaning of state exemptions applicable to public assistance grants generally.6 Such courts reason that “the clear purpose and effect of the earned-income credit is public assistance.” In re Brasher, 253 B.R. 484, 489 (M.D. Ala. 2000). “Economically, the earned-income credit does not function as ‘mere tax relief’ but rather is ‘in essence, a grant.’” Id. (quoting In re Longstreet, 246 B.R. 611, 614 (Bankr. S.D. Iowa 2000)). This view is consistent with the notion that exemptions are to be construed liberally in favor of the debtor. See In re Foah, 482 B.R. 918, 921 (10th Cir. BAP 2012); In re Bushey, 559 B.R. 766, 774 (Bankr. D.N.M. 2016); Hewatt v. Clark, 44 N.M. 453, 1940-NMSC-044, ¶ 15. Such liberal construction effectuates the humanitarian purposes of exemption provisions. Foah, 482 B.R. at 921 (citing In re Carlson, 303 B.R. 478, 482 (10th Cir. BAP 2004)). Generally, the “purpose of having exemptions is to permit a debtor to retain certain necessities . . . without fear of creditors taking them.” In re Warren, 512 F.3d 1241, 1249 (10th Cir. 2008); In re Bushey, 559 B.R. 766, 771 (Bankr. D.N.M. 2016) (quoting Warren). The New Mexico exemption statute in particular was “adopted as a humane policy to prevent families from becoming destitute as the result of misfortune through common debts which generally are unforeseen.” Hewatt v. Clark, 44 N.M. 453, 1940-NMSC-044, ¶ 13 (internal quotation omitted).

However, at least one court has held that EITC tax refunds do not fall within a broad state exemption for “public assistance” because an EITC tax refund is a “tax overpayment” and not a “welfare grant.” See In re Trudeau, 237 B.R. 803, 807 (10th Cir. BAP 1999). This Court disagrees.7 An EITC tax refund is not dependent on the amount of tax paid and is available even to a qualified taxpayer who pays no tax at all. The EITC is not a refund attributable to an actual tax overpayment.

6E.g., In re James, 406 F.3d 1340, 1343-45 (11th Cir. 2005) (holding that EITC was exempt under Alabama exemption for “public assistance for needy persons”); In re Corbett, No. 13-60042, 2013 WL 1344717, at *2-3 (Bankr. W.D. Mo. Apr. 2, 2013) (holding that EITC was exempt under Missouri exemption for “public assistance benefit”); In re Fish, 224 B.R. 82, 84-85 (Bankr. S.D. Ill. 1998) (holding that EITC was exempt under Illinois exemption for “public assistance benefit”); In re Tomczyk, 295 B.R. 894, 896-97 (Bankr. D. Minn. 2003) (holding that EITC was exempt under Minnesota exemption for “all relief based on need”); In re Moreno, 629 B.R. 923, 932-34 (Bankr. W.D. Wash. 2021), aff’d, No. WW-21-1124-LBS, 2021 WL 6140115 (9th Cir. BAP Dec. 23, 2021) (holding that EITC was exempt under Washington exemption for “assistance”); Flanery v. Mathison, 289 B.R. 624, 628-29 (W.D. Ky. 2003) (holding that EITC was exempt under Kentucky statute exempting “public assistance benefits”); In re Longstreet, 246 B.R. 611, 617 (Bankr. S.D. Iowa 2000) (holding that EITC was exempt under Iowa exemption for “public assistance benefit”); In re Jones, 107 B.R. 751, 751-52 (Bankr. D. Idaho 1989) (holding that EITC was exempt under Idaho exemption for benefits provided by “public assistance legislation”).

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