This issue was recently addressed by the 9th Circuit Court of Appeals in the case of Nichols v. Birdsell, 2007 U.S. App. LEXIS 10919 (9th Cir. 2007).

The Court ruled that pre-petition tax refunds are property of the estate and may not be applied to pay the Ch 7 Debtor’s post-petition taxes..

In this case, the Debtors overpaid their 2001 federal and state income taxes and were entitled to tax refunds. The Debtors elected not to get a current refund but rather left those funds on deposit with the IRS and State of Arizona in order to apply the overpayments to these future tax liabilities.

Sixteen days after the election, on February 5, 2002, the Debtors filed for Ch. 7 bankruptcy. In February 2003, the Debtors signed their 2002 tax returns and applied the deposits from their 2001 taxes to their 2002 tax liabilities.

The Debtors argued that after making the election, they were no longer entitled to a tax refund. They argued that the after the election (which occurred pre-petition), they no longer had an interest in the tax refund. The Trustee sought to recover the overpayments and argued that the funds were assets of the estate under section 542(a) of the Bankruptcy Code. The bankruptcy court agreed with the Trustee and ruled in his favor. The Debtors appealed to the district court, who affirmed the bankruptcy court’s ruling. Debtors then appealed to the 9th Circuit Court of Appeals.

The Court analyzed the issue and affirmed the bankruptcy court’s decision. The Court found that the right to a refund constitutes an interest in property, therefore the election to waive a refund also constitutes an interest in property.

The Debtors argues that their inability to get the funds after the election prevented the bankruptcy estate from asserting any right to the funds. However, the Court said that nothing in section 541 requires that the debtor’s interest in property be immediately capable of being liquidated into cash in order to constitute property of the estate.

The Court held that even though the funds were not immediately available, under the broad definition of property interest, the tax refund was property of the estate.

Ray