In this economic downturn, businesses and individuals are applying new rules to turn tax losses into tax refunds. However, the recipient of a tax refund may not always be who you think it is.
The Supreme Court of the United States and the Fourth Circuit Court of Appeals recently issued decisions regarding the ownership of tax refunds. In both cases, the taxpayers believed they were entitled to the refunds but the courts determined otherwise.
Parent Must Turn Refund Over to Subsidiary
In Rodriguez v. FDIC, a parent company and a subsidiary in a consolidated group both filed for bankruptcy. At issue was whether the parent or subsidiary owned a tax refund when the subsidiary was the consolidated group member that generated the losses that created the refund.
An affiliated group of corporations may file a consolidated federal tax return that reports the activities of all members of the group. If the consolidated return reports an overpayment of tax, the IRS will issue the refund as a single payment to the parent, and it is up to the group to determine how the refund will be split among the members.
Many consolidated groups create tax allocation agreements that specify what share of a group’s tax liability each member will pay as well as the share of any tax refund each member will receive. The Ninth Circuit, came up with the eponymous Bob Richards rule in a case of that name in 1973, stating that, absent an explicit agreement, a refund belongs to the group member responsible for the losses that led to it. Subsequently, several courts held that the Bob Richards rule should always be followed unless a tax allocation agreement unambiguously specifies a different result.
The Supreme Court held that the Bob Richards rule was not a legitimate exercise of federal common lawmaking and struck it down. The Court explained that common lawmaking should be used only in the unusual situation where there is a significant conflict between some federal policy or interest and the use of state law, and that it must be necessary to protect uniquely federal interests. In this situation, the Court held, state law is well-equipped to handle disputes involving property rights such as the one at issue here, and therefore the ownership of the refund should be determined without resorting to the Bob Richards rule.
Debtor Not Allowed to Retain Refund
In Copley v. United States, the taxpayers filed for bankruptcy and claimed a tax refund as exempt property while the IRS sought to retain the refund and use it to set off the taxpayers’ outstanding tax liability. At issue was the interplay of two statutes, one found in Title 26 (the “Tax Code”) and one found in Title 11 (the “Bankruptcy Code”).
The Tax Code provides that the IRS has the discretion to set off any tax overpayment against a taxpayer’s preexisting tax liabilities. As a result, a taxpayer who files a return claiming a refund will only receive that amount if they do not owe tax for any other year.
The Bankruptcy Code provides that a taxpayer may claim certain property as exempt from the bankruptcy estate and therefore retain ownership of that property. Such property may then not be used to satisfy any of a debtor’s debts incurred prior to the filing of the bankruptcy case.
In this case, the taxpayers filed for bankruptcy in 2014, and claimed a refund on their 2013 tax return. They sought to claim the refund as exempt from the bankruptcy estate such that the IRS could not use it to set off an outstanding tax liability.
The bankruptcy and district courts held that the taxpayers’ right to exempt the refund superseded the setoff rights of the IRS and ordered the IRS to issue the refund. The Court of Appeals reversed and held that the IRS’ right to offset cannot be subordinated or otherwise affected by the taxpayers’ attempts to claim the refund as exempt property.
Your Guide Forward
For taxpayers filing refund claims based on recently enacted legislation, incurring losses in the current year, facing bank foreclosures, or considering bankruptcy, it is important to consider the ownership of any tax refunds. For any questions or for additional guidance surrounding these complex issues, reach out to a member of your local Cherry Bekaert Team.
