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New Opinion Creates Split in Western District as to Whether Debtors Can Exempt Undisclosed Tax Refund That is Spent Post-petition.

In re O'Brien, Bankr. W.D. Mich., Jan. 4, 2011 (Case No. 09-00426, Hon. James D. Gregg).

As previously discussed on this blog, debtors should include a good-faith estimate of an anticipated tax refund in their bankruptcy schedules. In prior cases, the Hon. Jeffrey R. Hughes and the Hon. Scott W. Dales suggested that debtors may not be able to amend their schedules to exempt tax refunds that have already been spent at the time of the amendment. But in a recent opinion, the Hon. James D. Gregg disagreed with those cases and held that, depending on the circumstances, debtors may be able to exempt a tax refund that was not originally disclosed, even if the tax refund has been spent.

In In re O'Brien, the Chapter 7 debtors did not list any tax refunds in their original schedules. However, at their § 341 meeting, they disclosed to the trustee that they expected to receive federal and state refunds. The debtors amended their schedules 42 days after the § 341 meeting to disclose and fully exempt the refunds. The trustee objected to the amended exemption and filed a motion for turnover of the refunds, arguing among other things that the amendment was too late because the refunds had already been spent.

The bankruptcy court overruled the trustee's objection and denied his turnover motion. After reviewing the prior cases involving post-petition transfers of tax refunds, the court rejected the argument that debtors cannot belatedly exempt a tax refund because it is "already gone." The court reasoned that a debtor's right to receive a tax refund is property of the estate as of the date of filing (even if it is not scheduled), and an amendment to exemptions relates back to the date of filing. Thus, if an asset is property of the estate at the time of the filing (that is, it was not transferred away pre-petition), it generally can be exempted.

However, if the asset is transferred post-petition, the analysis is more complicated. The court reached the following conclusions:

  1. If the asset is already exempt when it is transferred, then the trustee cannot recover it because the debtor has "reclaimed" or removed it from the bankruptcy estate by exempting it.
  2. If the asset is not already exempt and is transferred post-petition, and if the trustee successfully avoids that transfer (e.g., files an avoidance action under § 549), then the debtor cannot then exempt the asset.
  3. If the asset is not already exempt, is transferred post-petition, and the trustee has not avoided the transfer, then the debtor may amend to exempt the asset.

For the debtors in O'Brien, the trustee had not avoided the post-petition transfer (the spending of the tax refund), so it was not too late for the debtors to amend their schedules and exempt the tax refund.

The court rejected the trustee's argument that debtors may only add property to their schedules during the 15 days after their bankruptcy filing. The court also found that as a factual matter, the debtors did not act in bad faith or conceal the refunds, and the court found that the trustee had not shown that sufficient prejudice resulted from the debtors' amended exemptions.

Finally, the court declined to sanction the debtors' attorney for failing to advise the debtors to list their estimated tax refund on their original schedules. But the court cautioned that an estimate should have been included and offered this simple rule: "When in doubt, 'overdisclose;' when exemptions are available, 'list them.'" Id. at 42.

This case will provide guidance in situations where an asset was omitted from the schedules and the debtor later wishes to exempt it. However, despite the debtor-favorable result, debtors' attorneys should still take care to include estimated tax refunds in the original schedules to avoid this kind of dispute in the first place.

Categories: Chapter 7, Western District of Michigan

Photo of Laura J. Genovich

practice focuses on bankruptcy, municipal law, collections, and trial-level and appeals litigation. In the bankruptcy arena, she represents primarily Chapter 7 trustees. Laura has handled a wide range of trial and appellate matters for individual and business clients and has appeared before the U.S. Sixth Circuit Court of Appeals, the Michigan Court of Appeals, and the United States Bankruptcy Court for the Western District of Michigan, as well as Michigan circuit and district courts across the state.

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