Property of the Bankruptcy Estate

**This article should be considered an incomplete article until further notice. The intent with this article is to establish a general article about property of the bankruptcy to which subsequent articles discussing the different specifics of property of the estate may refer. **

By definition, property of the bankruptcy estate includes: All legal and equitable interests of the Debtor in property as of the commencement of the case. 11 U.S.C. § 541(a)(1). When explaining this definition to a prospective client, I typically start with the paraphrase: Anything you can point to, whether you can see it or not, and say, “that is mine,” or “that should be mine,” or “that will be mine” is property of the bankruptcy estate.

The bankruptcy code broadly defines property of the estate with a few narrow exceptions. For instance one exception to property of the estate, found in § 541(b)(1), is any power the debtor may exercise solely for the benefit of an entity other than the debtor, i.e., a debtor’s fiduciary power under an express trust, or his managerial powers pursuant to his employment.

Whether an interest is property of the estate, at the moment the Petition is filed, is not left to the discretion of the debtor, trustee, or even the court. It is an objective determination based upon whether the asset falls within the definition in § 541(a).

There is often the question of whether a certain asset is property of the bankruptcy estate. While Federal law (i.e., Bankruptcy law) determines whether such asset of the debtor is property of the estate, state law determines whether the asset is property of the debtor.  So if state law recognizes the property being of the debtor, then Federal law will determine whether such property of the debtor is property of the estate.  Conversely, if state law does not recognize an asset as being property of the debtor, then there is no property of the debtor for Federal law to determine as property of the estate.

There is much to be discussed with regards to property of the estate.  And Debtors need to understand what constitutes property of the estate as their ignorance could put their discharge at risk.  When the debtor understands how broad the definition actually is, the debtor is better prepared for his bankruptcy.

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Is that an Heirloom in My Room?

What is an heirloom?  Is a gift from Mom an heirloom?  What about a gift from Grandma?  What if the gift was simply an ordinary aluminum boat you could pickup at Cabela’s?

Well, there are two criteria that must be met for an asset to be deemed an heirloom:

1. the asset must be subject to multi-generational transfers, and

2. must possess unique characteristics that differentiate it from other similar items, such as antiquity, novelty, or history.

The exemption statute at issue here, Idaho Code § 11‐605, provides:

(1) An individual is entitled to exemption of the following property to the extent of a value not exceeding seven hundred fifty dollars ($750) on any one (1) item of property and not to exceed a total value of seven thousand five hundred dollars ($7,500) for all items exempted under this subsection:

* * * *
(c) Family portraits and heirlooms of particular sentimental value to the individual.

“An heirloom is “an item of property which has passed through at least one generation before it became property of the debtor.” In re Hearn, 97.1 IBCR at 22.  Stated another way, in order to achieve heirloom status, more than one generational transfer of the item in question is required.” In re Merrill, ID BK Case No. 12-40663-JDP, (Sept. 24, 2012).

“If this initial burden is met, the debtor must then show that the property has some characteristics of uniqueness that differentiate it from other similar items, such as antiquity, novelty, or history.” Id.

In the Merrill case, which only focuses on the first element, the Debtors’ son had purchased a boat from an aunt before he died intestate.  The Debtors took possession of the boat with the intention to pass it to their grandson when he reaches the age of majority.  Thus the boat really only passed from the Debtors’ son to the Debtors (the Court apparently did not consider the purchase of the boat a “generational transfer”).  So while this transfer between the Debtors’ and their son involves multiple generations (two), the asset must pass through at least one generation, not simply passed to one generation.  Thus at least 3 generations must be involved. 

“Even if this transfer from a descendant to an ancestor could be considered a passing of property from one generation to another, in the heirloom analysis, it represents but a single generational transfer, not the multi‐generational passing required by the case law in this District.” Id.

Thus a gift from Mom will not suffice as an heirloom.  I do not believe a gift from Grandma would suffice either – though I’m sure someone will try to argue that skipping a generation suffices as passing through it.

The two cases cited by Merrill appear to address only the first element, and not what constitutes sufficient “history” for an asset to have unique characteristics.  And I have not personally researched the issue, but I would surmise that if an asset satisfies the first element of an heirloom, then it likely has sufficient intrinsic history and sentimental value to meet the second element.  But again, that depends on the asset and the facts of each generational transfer – as I don’t think the issue is so clear with an aluminum boat Grandpa bought at Cabela’s 10 years ago and is now in the Debtors’ possession.

Income Tax Turnover Order

The Income Tax Turnover Order is an automatic order issued by the court when every Bankruptcy Petition is filed and remains in effect for the entire period during which a case is open.

It requires that a debtor do 3 things:

1. That a debtor file their State and Federal tax returns in a timely fashion (so either by April 15th or if an extension is filed, by October 15th).

2. That the debtor turn over to the trustee all tax returns that the debtor files for any tax year during which the bankruptcy case was open. This can span several tax years. I advise chapter 7 debtors that even if their case is currently closed, if it was open during the tax year, then forward a copy of the tax returns to the trustee.

3. That the debtor turned over to the trustee all tax refunds the debtor possessed on the petition date, or received while the case is open.

In a chapter 7 case, the Income Tax Turnover Order also requires that a chapter 7 debtor file all pre-petition tax returns that were required to have been filed but were not filed.

Current Monthly Income (CMI)

In every single individual consumer bankruptcy case, the debtor’s Current Monthly Income (“CMI”) must be calculated.  So just what is a debtor’s Current Monthly Income?  Well, its not what the debtor’s income currently is….I’ll tell you that!

It’s actually the quotient of the aggregate of income a debtor earns in the 6 calendar months prior to the month in which a debtor files his Bankruptcy Petition, divided by 6.  In other words, its the average of the gross income the debtor receives from all sources in the 6 months prior to filing a bankruptcy petition.

Current Monthly Income is a term defined by 11 USC 101(10A):

(A) means the average monthly income from all sources that the debtor receives (or in a joint case the debtor and the debtor’s spouse receive) without regard to whether such income is taxable income, derived during the 6-month period ending on—

(i) the last day of the calendar month immediately preceding the date of the commencement of the case if the debtor files the schedule of current income required by section 521 (a)(1)(B)(ii); or

(ii) the date on which current income is determined by the court for purposes of this title if the debtor does not file the schedule of current income required by section 521(a)(1)(B)(ii); and

(B) includes any amount paid by any entity other than the debtor (or in a joint case the debtor and the debtor’s spouse), on a regular basis for the household expenses of the debtor or the debtor’s dependents (and in a joint case the debtor’s spouse if not otherwise a dependent), but excludes benefits received under the Social Security Act, payments to victims of war crimes or crimes against humanity on account of their status as victims of such crimes, and payments to victims of international terrorism (as defined in section 2331 of title 18) or domestic terrorism (as defined in section 2331 of title 18) on account of their status as victims of such terrorism.

For example, say the debtor files his petition on July 1.  He will need to add up all the gross income he received from January 1 – June 30, then divide it by 6.  This will provide his CMI.  If he files on July 31, he’ll need to add up that income during the same time period.  But should he file on August 1, the CMI period shifts to February 1 – July 31.

The formula requires the debtor include in the calculation income from all sources but for three exceptions:

1. The debtor does not include income received by way of the Social Security act – thus Social Security Income (SSI), Social Security Assistance (SSA), and Social Security Disability Income (SSDI) are not included;

2. Income the debtor receives on account of being a victim of war crimes or crimes against humanity, what I call “refugee income;” and

3. Income the debtor receives on account of being a victim of foreign or domestic terrorism

Now the calculation is rather simple for debtors who solely earn wages or other sources of steady and regular income (like disability or retirement income).  However the calculation can get tricky if the debtor is self-employed.  Even more so if the debtor derives income from operating an incorporated entity like an LLC or an Inc.  I’ll write about those cases later.

Tax REFUNDS in a Chapter 7

I’m talking about tax refunds, not returns.  There is a difference.  A tax return is the paper that you send to the taxing authority.  The tax refund is the actual money you get back from the taxing authority.  Tax refunds are property of the estate….well, not entirely….but mostly….well, that is the subject of this post: when are tax refunds property of the estate?

To answer the question, you must understand, exactly what tax refunds are.  Like I said, they are the $$$ that is returned to you by the taxing authority.  But its a little more complicated than that.  First off, while the amount of your refund, if any, is determined when completing your tax return, your right to that refund  actually vests at the end of the tax year for which your refund pertains.  So if for tax year 2011, you paid in more than your actual tax obligation, then your right to a refund vests on January 1, 2012 (even though the actual amount may not be determined until October, 2012, if you filed an extension).  Thus on January 1, 2012, your 2011 tax refund may be considered an account receivable, albeit for an unknown amount.  And since accounts receivables are considered property of the estate,  the 2011 tax refund may be considered property of the estate.

The extent of the bankruptcy estate’s interest in  a tax refund depends on the date you filed for bankruptcy relief.  As in the example above, if a debtor were to file for relief on January 1, 2012, his entire 2011 tax refund would be property of the estate.  The Bankruptcy Code requires that debtors file their tax returns as required by law and therefore the bankruptcy trustee will request turnover of the entire 2011 tax refund upon the debtor’s receipt.  So, if the debtor has yet to file his 2011 tax return before filing bankruptcy, 100% of the 2011 tax refund is property of the estate and will likely need to be turned over to the Trustee

The same is true if the debtor files bankruptcy after filing his tax returns but before receiving the tax refund.  Also, if he has received his tax refund and is still in possession of the refund, or any portion of it, at the time he files bankruptcy then he’ll be asked to turn over to the Trustee the portion of the refund debtor had in his possession at the time of the bankruptcy filing.  At this point, the debtor’s interest in the tax refund is likely an interest in cash, or, more likely, an interest in a bank account in which the funds are deposited.  Regardless of its disposition, if the debtor is in possession of the refund at the time of filing bankruptcy, the debtor must turn those funds over to the Trustee.

The scenario may be different if the debtor files bankruptcy after receiving his tax refund and spending the funds on reasonable and necessary goods (such as car repairs, bk atty fees, necessary food/clothing/maintenance items, housing repairs, etc.).  In this scenario, the 2011 tax refund was already received prior to the bankruptcy filing, thus it transformed from an account receivable to an asset – a diminishing asset.  If diminished prior to the filing of the bankruptcy, then, well, it is diminished and any residual is considered property of the bankruptcy estate (see previous paragraph); if fully diminished, however, then there is nothing for the bankruptcy estate.  (See below for comments regarding use of a tax refund prior to the filing of a bankruptcy.)

But what happens when a debtor files bankruptcy much later in the year….like October, 2012.  At that point it is very likely the debtor received his 2011 tax refund and spent it (assuming a tax return was filed in or before April).  However, it is also likely that the debtor will be filing another tax return in the next 6 months….so Bankruptcy Trustees, the sly devils they are, will seek the bankruptcy estate’s pro-rata share of the debtor’s 2012 tax refund, if there is one.  Basically, the Trustee calculates the bankruptcy estate’s percentage of the tax refund based upon the Petition date (the day the debtor filed bankruptcy).  So if the Debtor filed October 1, 2012, the Trustee will divide  275 (numbers of days lapsed prior to the Petition date + the Petition date) by 366 (total days in the year).  So in this instance the Trustee would get 275/366 (75.14%) of the debtor’s 2012 tax refund.

Sometimes tax refunds are the only asset a Trustee administers.  Thus, Trustee’s will hold cases open until they get a copy of the tax return – if it shows little to no refund, then they’ll likely file a no-asset report and allow the case to close.  However, if there is a sufficient refund, then the Trustee will likely elect to administer such funds and the  case will remain open until the Trustee is finished.

Notes Regarding Tax Refunds:

1.  The debtor cannot exempt his interest in his tax refund.  In fact the tax refund may be the only non-exempt asset a debtor has – which means that Trustee’s are keen on what happens to them.

2. A debtor’s liquidation of the tax refund will be scrutinized.  Thus, if you wish to spend your tax refund prior to filing bankruptcy, then understand that you will be asked how you spent such funds and why such an expense would be considered reasonable and necessary in your circumstances.  That means a debtor  should not spend his tax refund on a vacation, novelty or frivolous items, or other things not necessary for his welfare.  Some accepted expenses include groceries, car/house repairs or maintenance, bankruptcy attorney, catch up arrears on secured debt, medical expenses, and the like.  It is advised though that debtors consults with their attorney prior to the spending of tax refunds.

3. Due to the scrutiny that tax refunds get, which is rightly deserved, the better the debtor can show how those funds were used, the better it is FOR EVERYONE.  It is recommended that debtors deposit their tax refund into its own separate bank account; the account should start with a $0.00 balance, and should only reflect the deposit of the debtor’s tax refunds….nothing else.  Funds should be withdrawn from the account only by way of checks or POS transactions…that is it (i.e., no cash withdrawals or transfers to other accounts).  This way the bank, not the debtor, will generate a statement as to how those funds were used or disposed.  Also, the debtor should  not transfer funds from the “refund” account to some other “regular checking” account in order to use the funds; otherwise the Trustee will then need to review 2 checking account statements to determine how the funds were used.

Investment or Loan?

It’s hard to determine sometimes whether the  contribution to an enterprise is an investment or a loan.  The rule of thumb that I always went by was that if it was expected, at the time of the contribution, that the the contributor would earn a share of the enterprise’s profits, then it was an equity investment.  If it was expected that the contribution just be repaid (albeit with interest), then it is a loan.  An investor takes more risk that there might not be a return on his investment – and thus will have no recourse against the enterprise for it simply failing – but should the enterprise thrive, the investor will thrive as well.  The lender too has risk, but not as great as the investor.  And should the enterprise not repay the funds, the lender can seek legal remedies to collect on the loan.  However the lender does not get to thrive with the enterprise as the investor does – the lender simply gets paid back per the terms of the loan.

A recent case in our district,  In re Gables Management, had this very issue at matter when a chapter 7 trustee contended that a contribution to an enterprise was not a loan, but an investment and therefore not entitled to distribution from the estate.  In undertaking his analysis, Judge Pappas noted that the determination of whether a contribution is a loan or an investment requires a labor intensive analysis of the facts surrounding the contribution and the relationship of the parties at the time of the contribution and after.  The Court then applied the Howey-Forman factors: 1. contribution of money, 2. common enterprise, & 3. a reasonable expectation of profits to be derived from the entrepreneurial or management efforts of others.  The court found that the creditors’ contribution to the debtor was a loan, not an expectation of profits, and overruled the Trustee’s objection to creditors’ proof of claim.  It was this 3rd factor that turned in favor of the creditors.  I’m glad I still have my thumb.

Bankruptcy – The economy’s recycling tool

I dig bankruptcy.  I love how it empowers the individuals that must suffer through it.  A bankruptcy discharge (a permanent injunction enjoining the debtor’s creditors from collecting on debt from the debtor) provides debtors a financial fresh start.  It allows people to take chances, to try to make something of themselves, of their families, to try to be their own boss, to take financial risk with the understanding that should they fail, they can pick themselves back up and try again.

It is a wonderful pleasure to assist people in picking themselves back up and making their money theirs again.

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