In Marshall v. Blake, 885 F.3d 1065 (7th Cir. 2018) the Seventh Circuit accepted a certified appeal from the bankruptcy court and ruled that taxpayer’s earned income credit refund (EIC) could be prorated over the year. Both the procedure for certification of bankruptcy appeals and the method for calculating disposable income provide useful procedural information.
Before discussing the issues raised in the opinion, I would like to point out a related issue that bothers me in offer in compromise (OIC) submissions. The IRS pre-printed OIC contract permits the IRS to retain the debtor’s refund for the year in which the IRS accepts the OIC. This includes the EIC refund. In many cases, even if the IRS allowed taxpayers to keep their refunds and added the prorated amount to a taxpayer’s monthly income, monthly expenses will still exceed projected income. The EIC refund seeks to lift the taxpayer out of poverty. It is not a refund of funds withheld. Taking the refund hurts the children of the taxpayer as much as or more than the taxpayer. Many families rely on the EIC to purchase everyday items, as indicated by a recent Federal Reserve analysis. The analysis tracked retail sales following the 2017 congressionally mandated delay in tax refunds for EIC claimants. It noted that retail sales were much lower than previous years during the period in which refunds are typically issued, but peaked once the EIC was finally released. For a more detailed analysis, see Elaine Maag’s recent blog post. I think the IRS should not require offset of the taxpayer’s refund generated by EIC where the debtor’s schedules show allowable expenses in excess of income but should allow a refund recoupment bypass as cryptically described in IRM 5.19.7.2.21. Allowing the taxpayer to retain future refunds under these circumstances, makes economic sense because of the purpose of the credit. Taking the EIC portion of a taxpayer’s refund where the schedules demonstrate its need to meet basic living expenses just seems wrong. The Seventh Circuit shows a better way.
The trustee in the chapter 13 bankruptcy case seeks to have debtor turn over her entire refund each year to fund the plan. The debtor, a low-income wage earner, single mom living in subsidized housing with three dependent children, argues that the court should allow her to retain the portion of her refund attributable to the earned income tax credit allocating a portion of the credit each month to offset her reasonably necessary expenses. Her annual income of $30,000 falls well below the median income for a family of four in Illinois. In her schedules she included a pro rata share of her anticipated EIC. Doing this and subtracting payroll deductions and allowable expenses created for her the ability to pay $120 a month toward her chapter 13 plan.
The chapter 13 plan explicitly laid out her proposed use of the refund each year attributable to the EIC. The trustee filed a motion to dismiss the case for failing to correctly list her income and expenses. The trustee argued that the court should not confirm the plan because it failed to commit all of the debtor’s projected disposable income since it called for her to retain a portion of her annual refund. The debtor argued that the EIC should not count as income under the bankruptcy code. The bankruptcy court allowed the debtor to confirm a plan with a prorated version of annual income that would have her offset expenses throughout the year in a manner that would have her keep most or all of the EIC portion of the refund.
The court noted in its confirmation order that the debtor sought to purchase beds and furniture for her two 19 year old sons who had previously slept on air mattresses. The plan also proposed purchasing dressers for their bedroom which they previously did not have. These types of purchases created “a pretty skinny budget overall.”
The trustee moved for a direct appeal to the circuit court. The debtor objected. The normal path to the circuit court would involve a stop at the district court or a bankruptcy appellate panel; however, a direct appeal can occur in certain circumstances and the majority of the panel at the 7th Circuit citing 28 USC 158(d)(2)(A)(i) agreed that certification to the circuit “was appropriate because there is no controlling decision from the Supreme Court or the Seventh Circuit as to whether tax credits are disposable income under the Bankruptcy Code.”
Although the parties had argued in the bankruptcy court about whether to characterize the EIC credits as income, the circuit court recast the issue by focusing on the language of the bankruptcy statute. It looked at BC 1325(b)(1) which defines disposable income and BC 101 which defines “current monthly income.” It found that current monthly income includes the monthly income from all sources that the debtor receives “without regard to whether such income is taxable income.” The Seventh Circuit also looked at case law in reaching the conclusion that “Congress intended for the [EIC] to be included in the calculation of income.”
More importantly, however, the court found that just because current monthly income includes the EIC refund received by the debtor, that does not mean that the debtor must pay the entire refund to the trustee because the real issue in this case involves how the EIC works when calculating projected disposable income. The court noted that several bankruptcy courts in its circuit used the same calculus used by the bankruptcy court and allowed debtors to prorate future expense on which the debtor would spend the refund as long as such expenses met the reasonably necessary test.
The Seventh Circuit found that the holding here fits with the Supreme Court’s interpretation of projected disposable income. In Hamilton v. Lanning, 560 U.S. 50 (2010) the Court adopted a forward-looking approach to the question. It provided several reasons for approaching this issue with flexibility. It looked to the ordinary meaning of projected. The Supreme Court found that the mechanical approach adopted by the trustee in that case clashed with the provisions of BC 1325 and would produce senseless results in cases in which the debtor’s income during the six month lookback period was “substantially lower or higher than the debtor’s disposable income during the plan period.” Here, the bankruptcy court’s flexible approach aligned with the approach used by the Supreme Court.
The trustee argued that prorating the annual refund to a monthly amount artificially inflated the debtor’s income; however, the Seventh Circuit found that nothing in the bankruptcy code requires that current monthly income “is limited to income that is received on a monthly basis.” Rather, the bankruptcy code defines current monthly income as “the average monthly income from all sources that the debtor receives’ during the six-month lookback period.” The court describes the trustee’s objection to the plan as one driven by the fact that it allows the debtor to deduct reasonable expenses which reduces the amount that the debtor could use to fund plan payments.
The Seventh Circuit also found that allowing confirmation of this plan meets the good faith requirement of BC 1325(a)(3), that it meets the feasibility requirement in 1325(a)(6), and that it promotes the purposes of chapter 13. The dissenting opinion on the circuit court did not object to the holding on the merits but expressed concern that the case did not meet the criteria for direct appeal from the bankruptcy court.
The opinion avoids rigid treatment of the EIC just because it comes once a year. Though the court did not mention this, the EIC was available throughout the year prior to 2010 when Congress discontinued that option apparently because of the low uptake on the monthly option and the higher cost to employers. The impact allows debtors to project the true cost of their expense on an annual basis rather than treating the once a year payment as some sort of special payment that does not relate to the annual expenses. I would like to see the IRS adopt this approach in the treatment of OICs which have very similar considerations.