Overpaid Taxes Need Not be Turned Over to the Estate Under Section 542(a)

By: Christopher J. Rubino
St. John’s Law Student
American Bankruptcy Institute Law Review Staff

In Weinman v. Graves (In re Graves)[1], the Tenth Circuit held that section 542(a)[2] does not permit a chapter 7 trustee to force the IRS to turnover overpaid taxes of joint debtors where the debtors elected to apply the overpayment to the next year’s tax liability.  In Graves the joint debtors elected to apply their 2006 tax refund to their 2007 tax liability.[3]  Two months after filing their tax returns, the debtors filed for bankruptcy.[4] The Tenth Circuit affirmed the bankruptcy court’s refusal to order the IRS to turnover the debtors’ 2006 tax refund under section 542(a).[5] 

The Tenth Circuit held that the trustee could not force the IRS to turnover the tax refund at the time the motion was filed.[6]  Instead, the trustee was only entitled to the portion of the refund that was attributable to prepetition earnings and remained after the refund had been applied to the following year’s tax liability.[7] The court stressed the irrevocable nature of the refund.[8] The court reasoned that the debtors’ election to apply the refund to future tax liability was irrevocable under section 6513(d) of the Internal Revenue Code.[9] Therefore, the debtors’ interest in the refund, and consequently the estate’s interest, was limited to the remainder of the refund, if any, after it was applied to the debtors’ 2007 tax liability.[10] Not all jurisdictions, however, accept the rationale laid out in Graves. In Nichols v. Birdsell (In re Nichols),[11] the Ninth Circuit held that the trustee could force the IRS to turnover the current refund of a debtor’s overpaid taxes.[12]  The Nichols Court focused on the expansive definition of property under § 541(a).[13]  Nichols also cited as dispositive one of the Ninth Circuit’s prior decisions,[14] holding that the irrevocable election to carry forward net operating losses[15] was avoidable by the trustee[16] under § 548(a)(1).[17]

Based on the Tenth Circuit’s emphasis on irrevocability in Graves, a bankruptcy court would likely be required to hold that other irrevocable tax elections, such as the election to carry forward net operating losses,[18] are not reachable by the trustee through turnover. In addition, the Tenth Circuit’s holding may allow debtors to shield their tax refunds from the bankruptcy estate, reducing the pool of assets that creditors would otherwise have been able to reach absent the refund-application election. Debtors may now be inclined to elect to apply tax overpayments to future tax liabilities before filing for bankruptcy in an attempt to preserve the refund so that they can use it to reduce their post-bankruptcy tax obligations.