Prior to the recent opinion issued by Judge Rosenthal in In re Trickett, 391 B.R. 657 (Bankr. D. Mass. 2008) , issued on July 25, 2008, there had been no reported decisions from the Bankruptcy Court for the District Of Massachusetts about the treatment of income tax refunds as property of the Bankruptcy Estate, and how the refunds would be allocated when only one spouse files a bankruptcy case but a joint income tax return was filed by the debtor and the non-debtor spouse. In fact, I could find only one other reported decision addressing tax refunds from the entire First Circuit, that being In re Gleason, 193 B.R. 387 (Bankr. D. N.H. 1996) (Vaughn, J.) (joint federal tax refund was property of the estate and not of non-debtor spouse who neither withheld nor paid estimated taxes, even though refund was based in part on non-debtor spouse's business losses), which was not cited by the Court in Trickett.

The debtor in Trickett filed a Chapter 7 bankruptcy case on December 21, 2007 (the "Petition Date"). The debtor and his non-debtor spouse filed joint income tax returns for 2007. The total federal and state income tax refunds received by the debtor and his non-debtor spouse were $4,522 (the "Refund"). The Court divided its analysis into three parts:

• A. Is any portion of the Refund property of the estate?
• B. Allocating the Refund between pre and post-petition portions.
• C. Determining extent of debtor's interest in pre-petition portion of tax refund.

The first issue that Judge Rosenthal dealt with was whether any portion of the Refund was property of the estate. Interestingly, the debtor did not argue that because the bankruptcy case was filed prior to January 1, 2008, that the Refund was not property of the estate. In other words, the debtor did not make the argument that, because the obligation to file a tax return did not arise until the end of the year, any resulting tax refund would not be property of the estate. That argument would have fallen on deaf ears, however, as the Court held that the pre-petition portion of the debtor's tax refund, indeed, is property of the estate. The Court cited Section 541 of the Bankruptcy Code ("all legal and equitable interests of the debtor in property as of the commencement of the case" is property of the estate) and its review of case law "noting that every court that has considered the issue has followed this approach".

Having found that the pre-petition portion of the Refund was property of the estate, the next step in the Court's analysis was the allocation of the Refund between pre and post-petition portions. The Court identified the issue as whether the "pro rata by days" allocation method advocated by the Chapter 7 Trustee was the appropriate mechanism. This method requires a calculation dividing a debtor's refund over a 365 day year and multiplying the result by the number of days from the beginning of the year to the Petition Date. The Court approved and adopted this method finding that it provided a "bright-line test that effectuates Congress's intent...". The Court clearly rejected the method of "dissecting" the debtor's tax return to analyze pre-petition withholding, deductions, credits, or exemptions.

Having determined the allocation method (and amounts) between the pre and post-petition refunds, the Court's next step was to determine the debtor's interest in the pre-petition portion of the Refund since the debtor has not filed a joint bankruptcy case. The Court first stated that this was a question of state law but that no Massachusetts law dealt directly with the issue. As a result, the Court's review of case law identified at least three approaches:

1. Apportion the Refund based on each spouse's withholding;
2. Allocate the Refund based on the income earned by each spouse;
3. Split the Refund equally between the spouses, the so called "50/50 refund rule".

Extensively citing the reasoning in In re Barrow, 306 B.R. 28 (Bankr. W.D.N.Y. 2004), and in In re Innis, 331 B.R. 784 (Bankr. C.D. Ill. 2005), the Court adopted the "50/50 refund rule". The Court noted that certain courts that had adopted the "50/50 refund rule" had permitted rebuttal evidence based on the history of the spouses' financial independence. (Among the relevant factors identified by the court in Barrow were (1) whether the taxpayers maintained separate bank accounts; (2) whether the taxpayers have filed joint returns in the past; (3) how the parties divvied up past refund checks; and (4) whether the parties own assets individually and are otherwise financially independent.). Judge Rosenthal disagreed with those courts and stated that he would allow only the narrow rebuttal evidence permitted by the court in Innis such as a domestic relations court order or an enforceable, written, prepetition contract between the parties such as a prenuptial agreement. Trickett has not been appealed.

IMPLICATIONS OF TRICKETT

Attorneys need to keep in mind that Judge Rosenthal's opinion represents the view of only one of what eventually will be five bankruptcy judges in the District Of Massachusetts. Moreover, these issues have not been subject to appellate review, at least in the First Circuit. Having said that, the opinion does provide guidance for practitioners. Trickett is the first reported decision in the District Of Massachusetts that establishes that even though the Petition Date is prior to the end of the year, any tax refund that may be received for that calendar year is property of the estate to be calculated, "per diem", by the number of days pre-petition. Further, if only one of the spouses has filed a bankruptcy case, but the tax return had been filed jointly, the tax refund attributed to the pre-petition time period will typically be divided evenly between the spouses.

PRACTICE POINTERS

Based on the Trickett decision, the pre-petition portion of income tax refunds is property of the estate and should be disclosed on Schedule B - Personal Property of the Schedules Of Assets And Liabilities filed with the Voluntary Petition. Failure to disclose potential tax refunds as an asset could prompt an objection by a creditor or the trustee that any exemption in the tax refunds should be denied in its entirety. Understandably it is difficult to determine the "current market value" of such an asset when the income tax returns have not yet been prepared. As a result, it is likely that the value will be listed as "unknown" or "uncertain". Counsel To Debtor, however, is likely to have the prior year's tax return available in order to determine the likelihood of the debtor receiving income tax refunds for the calendar year of the bankruptcy filing. If Counsel To Debtor was not previously obtaining copies of tax returns for prior years, which would be "best practice", he/she is now required to do so as a result of the Bankruptcy Abuse Prevention And Consumer Protection Act ("BAPCPA") enacted in 2005, which requires that the most recently filed federal income tax return be provided (in most districts throughout the country) to the panel trustee at least seven days prior to the Meeting Of Creditors. A review of the tax returns should disclose what refunds were received in prior years and one should be able to determine whether similar tax refunds will be received for the current tax year. If substantial, then the debtor may want to claim an exemption in the refunds if "room" is available under 522(d)(5) ("catch all" or "wild card" exemption) of the Bankruptcy Code. Unfortunately, if Massachusetts exemptions need to be used, for example, to exempt substantial equity in a homestead, there is no exemption available to protect income tax refunds.

PRE/POST BANKRUPTCY PLANNING CONSIDERATIONS

As with all pre bankruptcy planning, counsel needs to be cautious, however, these options might be considered but probably not without discussion with the debtor's tax preparer or accountant:

• Increase the number of withholdings which would likely reduce any tax refund
• File the bankruptcy case after the prior year's refunds have been received and used appropriately but as early in the current calendar year as possible. This will not only reduce the potential tax refund but make the time for receipt of any tax refund be so far off that a Chapter 7 Trustee would not want to keep the case open for that long for an uncertain and potentially modest asset.
• Filing of a "short year" tax return; see 26 U.S.C. (Internal Revenue Code) 1398(d)(2)(D).
• A married debtor may want to prepare draft tax returns as "married filing jointly" and "married filing separately" status to determine what the tax implications of each classification might be. In some situations, the "married filing separately" may ultimately benefit the debtor's family.

TWO OTHER RELATED CASES

• In re Bailey, 380 B.R. 486 (6th Cir. BAP 2008) (debtors had to turn over tax refund as non exempt property of the estate even though they no longer had the refund money at the time of the turnover request; Section 542 of the Bankruptcy Code cited by the Court for its holding that the property "or the value of such property" had to be turned over to the Bankruptcy Estate).
• Nichols v. Birdsell, 491 F.3d 987 (9th Cir. 2007) (debtors applied overpayment of taxes, that would have otherwise been tax refunds, to their possible future tax liabilities; Court held that tax "credits" were property of the estate and debtors obligated to turn over the value to the Estate.).

LIFE INSURANCE EXEMPTIONS UNDER MASSACHUSETTS LAW

The summary:
The beneficiary must: 1. have been the original beneficiary when the policy was effected; 2. be an entity other than the owner; and 3. have an insurable interest in the insured.

The cases:

• In re CRS Steam, Inc., 217 B.R. 365 (Bankr. D. Mass. 1998) (Queenan, J.)
• In re Sloss, 279 B.R. 6, 14 (Bankr. D. Mass. 2002) (Boroff, J.)
• In re Caron, 305 B.R. 614, 616 (Bankr. D. Mass. 2004) (Rosenthal, J.)
• In re Chevalier, 330 B.R. 21, 26 (Bankr. D. Mass 2005) (Boroff, J.)
• In re Levesque, 2008 WL 3893705, (Bankr. D. Mass. 2008) (Feeney, J.)

The statutes:

Chapter 175: Section 119A. Insurance benefits; protection of beneficiaries

Section 119A. If, under the terms of any annuity contract or policy of life insurance, or under any written agreement supplemental thereto, issued by any life company, the proceeds are retained by such company at maturity or otherwise, no person entitled to any part of such proceeds, or any installment of interest due or to become due thereon, shall be permitted to commute, anticipate, encumber, alienate or assign the same, or any part thereof, if such permission is expressly withheld by the terms of such contract, policy or supplemental agreement; and if such contract, policy or supplemental agreement so provides, no payments of interest or of principal shall be in any way subject to such person’s debts, contracts or engagements, nor to any judicial processes to levy upon or attach the same for payment thereof. No such company shall be required to segregate such funds but may hold them as a part of its general corporate funds.

Chapter 175: Section 125. Creditors or beneficiaries; rights

Section 125. If a policy of life or endowment insurance is effected by any person on his own life or on another life, in favor of a person other than himself having an insurable interest therein, the lawful beneficiary thereof, other than himself or his legal representatives, shall be entitled to its proceeds against the creditors and representatives of the person effecting the same, whether or not the right to change the named beneficiary is reserved by or permitted to such person; provided, that, subject to the statute of limitations, the amount of any premiums for said insurance paid in fraud of creditors, with interest thereon, shall enure to their benefit from the proceeds of the policy; but the company issuing the policy shall be discharged of all liability thereon by payment of its proceeds in accordance with its terms, unless before such payment the company shall have written notice, by or on behalf of a creditor, of a claim to recover for certain premiums paid in fraud of creditors, with specification of the amount claimed. No court, and no trustee or assignee for the benefit of creditors, shall elect for the person effecting such insurance to exercise such right to change the named beneficiary. Any person to whom a policy of life or endowment insurance, issued subsequent to April eleventh, eighteen hundred and ninety-four, is made payable may maintain an action thereon in his own name.

Chapter 175: Section 126. Married woman; beneficiary under insurance contract

Section 126. Every policy of life or endowment insurance made payable to or for the benefit of a married woman, or after its issue assigned, transferred or in any way made payable to a married woman, or to any person in trust for her or for her benefit, whether procured by herself, her husband or by any other person, and whether the assignment or transfer is made by her husband or by any other person, and whether or not the right to change the named beneficiary is reserved by or permitted to the person effecting such insurance, shall enure to her separate use and benefit, and to that of her children, subject to the provisions of section one hundred and twenty-five relative to premiums paid in fraud of creditors and to sections one hundred and forty-four to one hundred and forty-six, inclusive. No court, and no trustee or assignee for the benefit of creditors, shall elect for the person effecting such insurance to exercise such right to change the named beneficiary.

CASE LAW

The beneficiary must have been the original beneficiary since the policy was effected. The exception to this “rule” appears to be that if the beneficiary, as of the Petition Date, is a “married woman” the exemption will be valid even if changed since inception. Sloss, 279 B.R. at 14. In footnote 11 of the Sloss opinion, however, the Court noted that neither party had addressed whether this gender based distinction passes muster under the Equal Protection Clause of the 14th Amendment to the U.S. Constitution, thus the court did not address the issue as well. Query what effect on the exemption if found to be unconstitutional? Would it result in the exemption becoming invalid, or construed in such a way that it would not offend the Constitution? An issue left for another day.

The beneficiary must be an entity other than the owner. In Chevalier, the debtor was an unmarried (divorced) woman who owned two life insurance policies for which her (eventual) probate estate was the beneficiary. Judge Boroff held that the mere designation of a probate estate as beneficiary disqualifies a policy from being exempt. In Levesque, Judge Feeney, citing the court’s opinion in Sloss, overruled the trustee’s objection to the exemptions claimed by joint debtors in reciprocal whole life insurance policies, finding that the beneficiary of each policy had not changed since inception. The court also noted the exemption available to a “married woman” but did not discuss the “insurable interest’ requirement, presumably because it was well settled that spouses have an insurable interest in the life of the other spouse.

The beneficiary must have an “insurable interest” in the life of the insured for the cash value of the policy to be exempt. Typically this means an immediate family relationship like a spouse or child. In CRS Steam, the exemption was denied because the beneficiaries of the policy were found to be the debtor's nieces and nephews who did not have an insurable interest in the life of an uncle. There is an exception if a parental or pecuniary relationship exists between the parties. CRS Steam, 217 B.R. at 369. In Caron, the court overruled the Trustee's objection to the debtor’s exemption claimed in the cash value of the life insurance policy even though the beneficiary of the policy as of the Petition Date was the debtor's former husband. Judge Rosenthal found that the statute only required that the beneficiary have an insurable interest in the life of the insured at the time the policy was “effected” (i.e., inception) and not at the time of the Petition Date. The court found that spouses have an “insurable interest” in each other’s lives and since the beneficiary was the husband of the debtor at the inception of the policy, the exemption claimed under M.G.L. ch. 175, § 125 was valid.

PRACTICE POINTER

Obtain information about the life insurance policy to determine the owner, the insured, the beneficiary, and the cash surrender value. A beneficiary history should also be obtained. Although the current state of the law protects the value of the policy if the beneficiary is a married woman, even though the beneficiary has been changed since inception of the policy, that protection could eventually be challenged. See, e.g., Sloss and Chevalier.