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How Overpaid Taxes Might Become Property of the Estate

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2 Copyright © American Bankruptcy Institute Interest in a Debtor's Right to Tax Overpayments for Pre-Petition Years May 2017 By Jeana ReinBold T he Internal Revenue Service (IRS) requires that everyone pay taxes on income they receive during the year, whether it is from a job, self-employ- ment or other sources. 1 The IRS expects to receive tax payments as income is earned, not just at the end of the year when a tax return is filed. 2 The fed- eral income tax is referred to a pay-as-you-go tax, and there are two ways to pay as you go. 3 The first way to pay federal taxes is through withholding taxes. Employers typically withhold income or other tax on an employee's behalf. 4 The amount withheld is paid to the IRS by the employer in the employee's name. 5 The second way is through payment of estimated tax. 6 Estimated tax is a method of paying tax on income that is not subject to withholding tax, and is paid directly to the IRS by individuals who do not have their taxes withheld. 7 This can include income from self-employment, business earnings, interest, rent, dividends and other sources. 8 Such withholding or estimated tax payments ordinarily will be applied to a debtor's federal tax liability, which arises at the close of the taxable year. 9 The general rule is that the filing of a bankruptcy case does not change the taxable year of the debtor, unless the debtor takes the short tax year election as set forth in § 1398 (d) (2) of the Internal Revenue Code (IRC). 10 This might mean that a debtor's right to overpay- ments as of the date that a bankruptcy case is filed becomes property of the estate subject to § 541 of the Bankruptcy Code. 11 This might also be the case — even if the debtor elects to apply such overpayments to a future tax return. 12 1 See generally "What Is Estimated Tax and Who Does It Apply To?," IRS, available at irs.com/articles/what-estimated-tax-and-who-does-it-apply (unless otherwise indicated, links in this article were last visited on March 27, 2017). 2 Id. 3 See "Tax Withholding," IRS, available at irs.gov/individuals/employees/tax-withholding. 4 Id. 5 Id. 6 Id. 7 Id. 8 See supra n.1. 9 See, e.g., In re Polichuk, 506 B.R. 405, 427 (Bankr. E.D. Pa. 2014); Klein v. C.I.R., 135 T.C. 166, 174 (2010) 10 See 26 U.S.C. § 1398(d)(1) and (2). Section 1398 (d) (2) provides that "Election to terminate debtor's year when case [under title 11 of the U.S. Code] commences — (A) In general. — Notwithstanding section 442, the debtor may (without the approval of the Secretary) elect to treat the debtor's taxable year which includes the commencement date as [two] taxable years — (i) the first of which ends on the day before the commencement date, and (ii) the second of which begins on the commencement date." 11 See, e.g., 11 U.S.C. § 541; Nichols v. Birdsell (In re Nichols), 491 F.3d 987, 990 (9th Cir. 2007). Overpayments for the purpose of this article are defined as any amount resulting after the application of these withholding/ estimated payments to pre-petition tax liability. 12 Id. Jeana K. Reinbold Springfield, Ill.

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