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Debtors Not Required to Turn Over Tax Refund Spent Before Converting to Chapter 7 - In re Salazar

March 30, 2012

It's getting close to tax time, and that means a lot of people who are in bankruptcy, or considering it, may have questions about the way their taxes are affected by their financial situations. Vincent Howard and our Redlands personal bankruptcy attorneys were thus interested to see a timely ruling on tax refunds from the Bankruptcy Appellate Panel of the Ninth U.S. Circuit Court of Appeals. In In re Salazar, Timothy and Gena Salazar originally filed for Chapter 13 bankruptcy, but eventually converted to Chapter 7. While the Chapter 13 was still in effect, however, they received and spent tax refunds on their living expenses. After the conversion, Chapter 7 trustee Lawrence Warfield moved to compel them to turn over the amount of the refunds, but the bankruptcy court found it was no longer part of the estate. In this opinion, the BAP of the Ninth Circuit agreed.

The Salazars, of Arizona, filed for bankruptcy in September of 2008. In their petition, they did not disclose that they had tax refunds coming, despite language expressly mentioning such refunds. They later received refunds of their 2008 federal and state taxes, and spent them on living expenses, without amending their bankruptcy schedules to disclose them. The total amount was $4,084.94. However, no bankruptcy plan was ever confirmed for their Chapter 13 case, and in August of 2009, they converted to Chapter 7. Warfield, the trustee, moved to compel that they turn over the refunds. The Salazars argued that because the money had been spent, it was no longer in their possession and could no longer be property of the bankruptcy estate, under the section of the bankruptcy code dealing with conversion of cases. The bankruptcy court agreed, and Warfield appealed.

The BAP noted that both parties agreed that the tax refunds should have been property of the Chapter 13 estate, even though the Salazars failed to mention it. They also agreed that they would have had to turn over the money during the conversion from Chapter 13 to Chapter 7, if they had not spent it. However, they disagreed about whether the law would consider property of the converted bankruptcy estate to be property in the estate as of petition, or as of the date of conversion. The bankruptcy code is somewhat confusing on this issue; it says a converted case's estate property should "consist of property of the estate, as of the date of filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion." Notwithstanding dueling caselaw, the BAP found that the plain language of the statute makes the prepetition refund not the property of the Chapter 7 estate. It recognized that this creates a somewhat unfair result, with the debtors able to spend money they would otherwise have had to turn over to the Chapter 7 or Chapter 13 estate, but it did not find the result absurd enough to disregard the plain language of the statute.

Vincent Howard and our Orange County consumer bankruptcy lawyers suspect we'll see this issue again -- either on appeal to the full Ninth Circuit or in another court. As the BAP notes, the result is somewhat unfair to debtors who don't convert from Chapter 13 to Chapter 7, because debtors like the Salazars are able to keep money that by rights they should turn over. However, we agree with the panel that people in the Salazars' position are and should be subject to scrutiny for "good faith" in their use of the money. The Salazars spent their tax refunds on basic living expenses rather than luxuries; even the trustee did not make a bad faith argument. Courts will have to examine this on a case-by-case basis, but our Los Angeles individual bankruptcy attorneys believe this is a good thing, giving the court room to exercise its considerable discretion.

If you're considering bankruptcy as a way to deal with overwhelming debts, you should call Vincent Howard and the team at Howard Law, P.C., to discuss how we can help. For a consultation, you can reach us through our website or call 1-800-872-5925 today.

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