“I thought I discharged my back taxes in bankruptcy! But the IRS just took this year’s tax refund and applied it to a year that was discharged!”
IRS Takes Tax Refund For Taxes Discharged in Bankruptcy
I hear this all the time from clients. But the IRS and California’s Franchise Tax Board can do this. Here’s why. Let’s say you filed bankruptcy in June 2024, and will get your discharge in October, erasing everything you owe the IRS for tax years 2011 to 2019. Break out the champagne! However, let’s also say you are over-withholding taxes this year and expect a tax refund for 2024. You expect to file, on extension, in October 2025, a year after your bankruptcy discharge.
Instead of a refund, you get a letter from the IRS in December 2025, thanking you for your overpayment. Which the IRS isn’t refunding, as you expected, but rather applying to your 2011 tax liability. The one you thought was discharged in the bankruptcy in 2024. Huh? What just happened? You’re obviously unhappy. Very unhappy.
IRS Can Offset a Tax Refund Against a Tax Liability Existing on the Date of a Bankruptcy Petition
The short answer: the IRS is allowed to set off a refund against a liability existing on the petition date 11 U.S.C. 553(a). The statutory language is:
“[T]his title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case . . .”
In June 2024, the day before the petition, the debtor certainly owed taxes – that’s the “claim of such creditor that arose before the commencement of the case . . .” But the IRS didn’t have a “mutual debt owing by such creditor to the debtor that arose before the commencement of the case” – or so you think, if you have not been exposed to “Tax Logic”.
The IRS treats each tax year as a single point in time, collapsing all 365 days of the year into one account. The bankruptcy petition was filed in June 2024. On that date, under fictions created by tax law and administered by the IRS, the IRS held the entirety of the 2024 refund – even though no one knew how much that refund would be. Actually, under tax law, the IRS held the entire refund as of January 1, 2024, regardless of when (within the 2024 calendar year) the taxpayer actually earned money and paid withholdings to the IRS.
Refund Will Be Given in the Next Tax Year
Bottom Line? This taxpayer will not be able to receive a refund until the next tax year after the tax year in which the petition was filed. In this example, that would mean that she could get a refund for 2025, payable sometime in 2026. Our taxpayer would not need to apply or do anything to get the refund. It will be generated automatically by the IRS.
Has the IRS Done Something You Don’t Understand or They Aren’t Explaining In A Way You Can Understand? Call Me!
September 12, 2024