Tax Notes logo

The Perils of Electing to Carry Forward a Tax Refund When Filing Bankruptcy

Posted on May 17, 2023

In Miller v. Wylie, No. 21-04012 (Bankr. E.D. Mich. 2023) the debtors elect to carry forward their tax refunds for returns filed shortly before bankruptcy and immediately after filing. Although the analysis for the pre- and post-bankruptcy elections turns out differently, the post-bankruptcy election causes the loss of their bankruptcy discharge under BC 727(b)(2)(B). I have seen occasional cases with this issue over the past few decades but have not written about it previously. The timing of bankruptcy filing versus return filing and the ability to elect on a return to carry a refund forward has tempted debtors to try this technique for preserving an asset that their creditors deserve. The existence of both pre- and post-bankruptcy elections in this case provides a detailed look at the considerations undertaken by a bankruptcy court when debtors make this type of election.

The Wylies filed a joint chapter 7 petition on August 27, 2020. To reach the decision in this case the bankruptcy court held a four-day trial – Wow. The refund issue relates to both state (Michigan) and federal tax refunds. I will focus on the federal refunds.

Like many other debtors the Wylie’s filed their tax returns late. Unlike most debtors, they filed seeking a substantial refund rather than posting more debt. Their 2018 return was filed almost one year late on March 31, 2020, just five months prior to the filing of their bankruptcy petition. The return claimed a refund of $21,317.00 and their state return filed at the same time claimed a similar sized refund. They elected to have the overpayments reflected on these returns applied to their 2019 income tax liabilities as estimated taxes.

There is nothing wrong or underhanded about making such an election as a general matter which is why the Internal Revenue Code permits such an election. Because the returns were filed with five months of the filing of the bankruptcy petition, the trustee alleges that the election amounted to a transfer which concealed their property with the intent to hinder, delay or defraud a creditor within the meaning of BC 727(a)(2)(A).

The Wylie’s filed their 2019 returns on September 15, 2020, almost immediately after filing their bankruptcy petition. Note that even though the return was filed after the bankruptcy petition the liability/overpayment for 2019 taxes was a prepetition liability or overpayment because the 2019 tax year ended on December 31, 2019, which date occurred prior to the filing of the bankruptcy petition.

The federal tax overpayment for 2019 on their return was $20,798.00 essentially resulting from the 2018 overpayment election with a similar result for their Michigan taxes resulting in over $40,000 in tax overpayments for 2019. What did the Wylie’s do with this $40,000? They elected to apply it to their 2020 tax liability. The trustee alleges that this election sought to transfer and conceal property of the estate with the intent to hinder, delay, or defraud the trustee within the meaning of BC 727(a)(2)(B). Because this election occurred after the filing of the bankruptcy petition it triggered a slightly different code section and it creates significantly more problems for the Wylies.

The court next turns to what the Wylies reported on their bankruptcy schedules. Debtors who file bankruptcy must file extensive schedules disclosing their assets and do so under penalties of perjury. The Wylies made at least two statements about their tax refunds which troubled the trustee whose job involves collecting all of the available assets for the benefit of the creditors. First, the Wylies said the value of tax refunds owed to them was unknown. More troubling they said:

Payment of $13,000 total, $10,000 to IRS and $3,000 to state of Michigan on October 2, 2019, towards estimated income tax liability. 2019 returns have not been filed. Payment amount was estimated to equal the tax liability.

Note the omission of information regarding the election to carry forward their 2018 overpayment.

The bankruptcy court notes the burden of proof here regarding the statute violation rests with the trustee. It then goes over the elements the trustee must prove and the case law surrounding those elements. Look to the case for a detailed discussion.

BC 727(a)(2)A) Discharge Denial Request

With respect to the pre-petition election to carry forward their 2018 overpayments the court found the election to be a transfer that concealed their property. The trustee cited to several of the cases I had read over the past decades in which debtors tried to conceal tax refunds using essentially the same technique as the Wylies:

Case law on this subject, cited by the Trustee, supports the Court’s conclusion that the Debtors made a “transfer,” and the Debtors have cited no case law to the contrary. See United States v. Sims (In re Feiler), 218 F.3d 948, 955, 956 (9th Cir. 2000) (bankruptcy debtors’ pre-petition tax election to carry forward net operating loss (“NOL”) to offset future income, and to waive NOL carryback and resulting tax refund, was a “transfer” of a property interest to the IRS); Gibson v. United States (In re Russell), 927 F.2d 413, 418 (8th Cir. 1991) (same, regarding bankruptcy debtor’s post-petition NOL election); Kapila v. United States (In re Taylor), 386 B.R. 361, 369 (Bankr. S.D. Fla. 2008) (same, regarding bankruptcy debtor’s pre-petition NOL election).

The court decided, however, that the pre-bankruptcy election did not meet the intent element of the statute because the trustee could not prove that the’ Wylies election, made five months prior to bankruptcy, sought to hinder, delay, or defraud a future chapter 7 trustee in a future bankruptcy case. The court viewed this election as a preference of the IRS over the Wylies other creditors. This type of preference could cause the funds transferred with a period prior to bankruptcy to be clawed back into the estate but would not rise to the level of denying a discharge. The court detailed at this point the severe health and financial problems facing Jason Wylie.

The court detailed the various businesses that Jason Wylie ran, his financial and health situation leading up to the bankruptcy, the timing of the hiring of the bankruptcy attorney, the reason for the delay in filing the 2018 return. Four days of testimony would have flushed out these details which provide crucial background for the court’s decision on discharge. Denying a discharge is a severe remedy the bankruptcy court would not take without care.

BC 727(a)(4)(A) Discharge Denial Request

The trustee sought to deny the discharge because of the false statements on the bankruptcy schedules. The court agrees the statements in the schedules were false but finds that the trustee did not prove the Wylies made these false statements fraudulently. So, as with BC 727(a)(2)(A) discharge denial request, the court turns away the trustee’s attempt to deny the discharge on this ground. One of the deciding factors for the court was that the Wylies provided their 2018 return to the trustee before or shortly after the filing of the petition and their 2019 return shortly after filing it. Because they were providing accurate information about the carry forward election at approximately the same time, the court determined that they did not intend to deceive the trustee with the false statements in the schedules.

BC 727(a)(2)(B) Discharge Denial Request

Here, the Wylies lose their discharge. The bankruptcy petition had already been filed. The 2019 refunds were clearly property of the estate. The court finds the carry forward election sought to transfer property of the estate with the intent to hinder, delay or defraud the trustee. By making the election the Wylies necessarily delayed the trustee since they could have received the refunds from the IRS promptly (a relative term during the pandemic) instead of forcing the trustee to unwind their election causing additional time and expense. (Under the facts here and probably because of the pandemic, the court finds that the election did not actually hinder or delay the trustee in obtaining the refunds but that is not controlling since they intended to do so.)

Jason Wylie and Leah Wylie both admitted in their trial testimony that the purpose of making their 2019 Tax Refund Transfers was the same kind of purpose they had when they made their 2018 tax refund elections — to try to make sure that their 2020 taxes would be paid.89 As the Court has discussed in Part III.C.1.b of this Opinion, this purpose is essentially a purpose to prefer the Debtors’ two taxing authority creditors (the Internal Revenue Service and the State of Michigan) over their other creditors. That is, the Debtors wanted to insure that their taxing authority creditors were paid in full, for 2020 taxes, in preference to their other creditors, many or most of which could not be paid in full.

In the post-petition context, the Debtors making a transfer of estate property with this purpose is wholly inconsistent with the duties of the Chapter 7 Trustee. This means that in substance, the Debtors had, at a minimum, an intent to hinder the Trustee. In the Debtors’ Chapter 7 bankruptcy case, the Chapter 7 Trustee would not and could not give the Debtors’ intended preferential treatment to these taxing authority creditors for 2020 taxes.

So, the debtors lose their discharge and the refunds come into the estate to pay creditors which could include the IRS depending on the various priorities of the creditors. The Wylies, unlike debtors in many of the previous cases I have read with this issue, do not appear to have the sneaky intent to use the carry forward to obtain the refund for themselves in a future year filing but rather appear genuinely desirous of making sure they covered their taxes. While their intentions are more noble than others using this technique to keep property out of the estate, the trustee is right to pursue the refunds for the benefit of all creditors in order that the priority scheme of the bankruptcy code is preserved. The bankruptcy court struggled with the decision to deny the discharge because of the intent issue.

Copy RID