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Lawsuit Against Chapter 13 Trustees May Not Cancel Redirection of Debtors' Tax Refunds - U.S. v. Carroll et al.

February 9, 2012

An extremely unusual bankruptcy appeal caught the eyes of our Lake Elsinore consumer bankruptcy lawyers. In U.S. v. Carroll et al., the Sixth U.S. Circuit Court of Appeals was not asked to decide a criminal matter or a lawsuit, but a challenge to bankruptcy court practices in the Eastern District of Michigan as they pertain to tax refunds. Because so few of the bankruptcies in the district had been completed, the court ordered that tax refunds be sent directly to Chapter 13 trustees rather than to the debtors. This created problems for the IRS, which eventually sued the trustees for a declaratory judgment disallowing the practice. The Michigan district court granted the judgment, but the Sixth Circuit vacated and ordered a dismissal, finding that the bankruptcy court was the correct defendant and the judgment against the trustees won't solve the problem.

The beginnings of the tax refund rule came in 2008, when several bankruptcy judges brainstormed a way to improve the rate of successful completion of Chapter 13 cases. These cases require three to five years of repayment according to a plan. In practice, these judges found that debtors often used the unexpected windfall of a tax refund as disposable income rather than to repay their debts. Thus, the bankruptcy judges of the Eastern District of Michigan began entering orders requiring the IRS to send tax refunds directly to bankruptcy trustees rather than the debtors themselves. The IRS originally had no problem with this, but because the agency had to process all such returns by hand, the paperwork became untenable as the number of affected taxpayers grew. Thus, the IRS's Chief Counsel asked the Department of Justice to sue, arguing that the redirection scheme violated the sovereign immunity of the United States. The district court granted a declaratory judgment stopping existing orders and a writ stopping new ones.

In an opinion that noted just how unusual the issues are, the Sixth Circuit reversed those decisions. The United States in this case is acting as a plaintiff defending sovereign immunity, where it usually makes that argument as a defendant. Meanwhile, bankruptcy trustees are not normally sued as a group, particularly not by the federal government. Perhaps because of this, the appeals court found that it lacked jurisdiction, because the government had sued the wrong party to start with. While the government has suffered an injury in fact from the administrative burden of handling the tax refunds, it said, it cannot show causation by the trustees; the harm flows from the orders of the bankruptcy court itself. Similarly, suing the trustees doesn't meet the standards for redressability because other parties may make the refund redirection request. Thanking the IRS for not wanting to sue federal judges, the Sixth suggested that it file one or more appeals of the redirection orders instead.

Underlying this highly unusual case is a problem that's present in every bankruptcy court: debtors who do not turn over all their income. While Vincent Howard and our Santa Ana personal bankruptcy attorneys understand the impulse to keep a tax refund, particularly for people who are in the middle of a bankruptcy repayment plan and feeling squeezed for extra money, debtors should keep in mind that withholding income has consequences. For one thing, withholding income keeps you from paying off your debts and finishing your bankruptcy plan. But it can also get you into trouble in court. Remember, the bankruptcy trustee is not your advocate; he or she advocates for creditors. If you have questions or concerns about how your income should be handled, we strongly recommend that you come to a Long Beach individual bankruptcy lawyer like Vincent Howard to discuss your options and their potential consequences.

If you believe you're too deep in debt to reasonably repay it and you're considering a bankruptcy, you should call Howard Law, P.C., to discuss how we can help. For a case evaluation, send us a message online or call 1-800-872-5925.

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