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Court ruling allows bankruptcy trustees to garnish tax refunds

While many people dread the approach of the April 15 deadline for filing their tax returns, many California residents also eagerly anticipate the reward: a federal tax refund. But for taxpayers completing a repayment plan under Chapter 13 of the Bankruptcy Code, the refund has been taken away in one judicial district in Michigan.

Things began in 2008, when judges noticed that their district was underperforming in the number of Chapter 13 plans successfully completed. To improve their numbers, they found a solution in ordering the IRS to send debtors' federal tax refunds directly to the bankruptcy trustees, who oversee a debtor's bankruptcy estate. The judges were concerned that debtors would spend the refund on themselves instead of distributing it to their creditors as required by their Chapter 13 plans.

The IRS did not oppose such orders initially and dutifully sent the refunds directly to the trustees. But it quickly became an administrative burden on the IRS, which had to process the debtors' returns by hand. When the number of bankruptcy filings spiked in 2009, the IRS became overloaded. At the request of the IRS, the United States brought a lawsuit to stop the direct payments to bankruptcy trustees and prevent them from being issued in the future.

A decision released last week by the 6th Circuit Court of Appeals sided with the bankruptcy trustees. The court's ruling concluded that the lawsuit failed because the federal government lacked standing, a legal concept that determines if a party can bring a lawsuit.

The bottom line is that, for the present, some people in a Chapter 13 reorganization plan may never see their tax refunds. The money will go directly from the IRS to the bankruptcy trustees.

Source: Sixth District Court of Appeals, "U.S. v. Carroll et al.," No. 10-1400, Jan. 30, 2012.

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