As I recently discussed at the National Bankruptcy Forum, the U.S. Bankruptcy Court for the Eastern District of Michigan recently posted a notice on its website regarding the treatment of tax refunds in Chapter 13 cases.  The notice (available here) reports that on January 20, 2010, in an action brought by the Internal Revenue Service, the U.S. District Court for the Eastern District of Michigan issued an Opinion and Order Granting Petition for Writ of Mandamus. This Order, issued in IRS v Carroll (available here) prohibits the Eastern District of Michigan Bankruptcy Court from confirming a Chapter 13 plan that contains a provision directing the IRS to pay the debtor’s tax refunds to the Chapter 13 trustee. Further, this Order prohibits the Chapter 13 trustees for the Eastern District of Michigan from seeking to enforce orders that have already been entered confirming a Chapter 13 plan, if such order directs the Internal Revenue Service to pay the debtor’s tax refunds to the Chapter 13 trustee instead of to the debtor.

More than a week after this Order was issued, Detroit bankruptcy attorneys continue to weigh the significance of this holding. The court’s Opinion in IRS v Carroll pointed out that the standard Michigan Chapter 13 plan form required the IRS to intercept tax refunds, and then to pay the refund over to the Chapter 13 trustee for payment to creditors, at the expense of the debtor.  This was problematic from the perspective of the IRS, because the IRS was not made a formal party to every chapter 13 proceeding involving tax refunds; consequently it had been given no opportunity to object to the Chapter 13 plans.  Some bankruptcy lawyers have suggested that this ruling might assist Chapter 13 debtors in keeping all or a portion of their tax refunds, because the IRS will no longer be paying tax refunds directly to the trustee.  If they are going to claim the debtor's tax returns, trustees will have to rely on other methods, such as turnover motions or motions to enforce Chapter 13 tax refund provisions against the debtors themselves; debtors may have defenses to such motions.

As I have said here before, if you are considering bankruptcy or have already filed a bankruptcy petition, and are expecting a significant tax return, discuss the issue with your bankruptcy attorney.

-Drew Broaddus