Bankruptcy Court Holds EITC Refunds Are Not Exempt From Creditors In Bankruptcy

The intersection of taxes and bankruptcy present interesting issues. A recent bankruptcy case demonstrated this by considering whether Earned Income Tax Credit refunds (and their New Mexico state equivalents) can be exempt from creditors in a bankruptcy proceeding. The case shows how the answer can depend on where you live! In this case, under New Mexico law, the bankruptcy court held that these refunds were not generally exempt from creditors.

In the case, the debtor was entitled to tax refunds, which were in part attributable to the Earned Income Tax Credit (EITC) and a New Mexico version, the Working Families Tax Credit. As the court explained, these credits are “intended to provide economic relief to low-income heads of household who work.”

The debtor listed the tax refunds under the state’s “wildcard” exemption, which allows a debtor to choose what property to exempt; however, the wildcard exemption here had a limit of $500. The bankruptcy trustee eventually objected to the claimed exemptions to the extent they exceeded the $500 limit.

This post will consider two of the arguments made in response to the trustee’s objection. First, that the EITC tax refunds were not part of the bankruptcy estate. Second, that the EITC tax refunds were exempt. The court ultimately disagreed with both arguments.

The bankruptcy court first considered the nature of the two tax refunds at issue: the federal Earned Income Tax Credit and the New Mexico Working Families Tax Credit.

The court explained that the “EITC is a refundable tax credit designed to help low-income individuals who work and earn an income.” Unlike other tax refunds, which are often attributable to tax overpayments during the year, the court noted that “the EITC can create a refund larger than the amount of tax paid throughout the year.”

The court explained the genesis and purpose of the EITC: “[1] to reduce the disincentive to work caused by the imposition of Social Security taxes on earned income . . . , [2] to stimulate the economy by funneling funds to persons likely to spend the money immediately, and [3] to provide relief for low-income families hurt by rising food and energy prices.” (quoting Sorenson v. Sec’y of the Treasury, 475 U.S. 851, 864 (1986)). Indeed, the court continued, “[a]fter numerous expansions, the EITC is regarded by many as the largest federal anti-poverty program in the United States.” (quoting In re Murray, 506 B.R. 129, 134 (10th Cir. BAP 2014), aff’d, 586 F. App’x 477 (10th Cir. 2014)).

Notably, though, the court also explained that “[d]espite its anti-poverty purpose, Congress has not enacted exemptions for EITC refunds similar to the protections for Social Security benefits under 42 U.S.C. § 407 and veterans’ benefits under 38 U.S.C. § 5301(a).”

The court then explained the New Mexico Working Families Tax Credit, which the court dubbed New Mexico’s version of the EITC. In a nutshell, the court explained that “[f]or the 2021 tax year, the New Mexico EITC is equal to twenty percent (20%) of an individual’s federal EITC.”

Next, the court considered whether the tax refunds were property of the bankruptcy estate.

In bankruptcy, the commencement of the case creates the “bankruptcy estate” under 11 U.S.C. § 541. In short, the bankruptcy estate contains, with some exceptions, “all legal or equitable interests of the debtor in property as of the commencement of the case.” 11 U.S.C. § 541(a)(1). Here, the bankruptcy court cited to 10th Circuit precedent that held that “a debtor’s EITC—pro-rated to the date of filing of the bankruptcy petition—is property of the estate.”

Based on this, the court concluded that the federal and state tax refunds were property of the bankruptcy estate.

The court next turned to the New Mexico exemptions. In bankruptcy, the debtor is allowed to “exempt” certain property, which means the property is not subject to (i.e., is exempt) from the claims of creditors. The exemptions are based on state law and thus vary from state to state. Here, therefore, the court considered the applicable New Mexico exemptions.

In this case, the debtor was using the state “wildcard” exemption, but as noted above, that had a $500 limit, which the tax refunds exceeded (and the trustee was objecting to the amount claimed in excess).

The court explained that some states have expressly passed statutes that exempt EITC refunds from creditors. For example, Colorado law exempts “[t]he full amount of any federal or state income tax refund attributed to an earned income tax credit or any child tax credit, whether as a refundable tax credit or as a nonrefundable reduction in tax” (Colo. Rev. Stat. § 13-54-102(1)(o)), and Nebraska law provides “[i]n bankruptcy and in the collection of a money judgment, the full amount of any federal or state earned income tax credit refund shall be exempt from attachment, garnishment, or other legal or equitable process and from all claims of creditors.” (Neb. Rev. Stat. § 25-1553.)

Here, in contrast to those states, the court emphasized that “New Mexico has not done so.”

The court also considered a statutory exemption for certain public assistance benefits. The court explained that some states have exemptions that apply to public assistance benefits. Even though the court concluded that the EITC refunds were public assistance, the court stressed the limited nature of New Mexico’s public assistance exemption. The New Mexico statute provided that “[a]ssistance granted under this act shall not be transferable or assignable, at law or in equity, and none of the money paid or payable under this act shall be subject to execution, levy, attachment, garnishment or other legal process, or to the operation of any bankruptcy or insolvency law.” (N.M. Stat. Ann. § 27-2-21.)

In interpreting this statute, though, the court noted that the exemption applies only to “money paid or payable under this act.” Thus, it did not exempt the federal or state EITC because neither were paid under the New Mexico Public Assistance Act.

Consequently, the court concluded that “federal EITC and New Mexico Working Families Tax Credit, despite having an anti-poverty purpose, are not exempted from the claims of creditors under the New Mexico Public Assistance Act or any other New Mexico exemption other than New Mexico’s $500 wildcard exemption.”

In conclusion, this case demonstrates an intersection of tax and bankruptcy law. Moreover, it shows how the bankruptcy effects of tax items—here, tax refunds—can vary depending on the state of the bankruptcy.

The case is In re Medina, No. 22-10233-j7 (Bankr. D.N.M. Dec. 16, 2022).

This is only a summary of the case and some portions—including facts, issues, or analysis—may have been omitted or edited; if you need advice in this area, please review the case in its entirety and consult an attorney.

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