Opinion
BK. No. 16-07962-LT7
09-01-2017
In re: Rita A. Church, Debtor.
WRITTEN DECISION - NOT FOR PUBLICATION
MEMORANDUM DECISION
Rita Church is retired and widowed. There is no dispute that during the relevant time period all of her income was exempt under California law. Prepetition some of this income was withheld and paid to taxing authorities. But Ms. Church was over-withheld, so postpetition most of the withheld income was returned to her as tax refunds which she claimed as exempt. The Trustee objected. Because California law allows for tracing in relation to exempt funds, the Court overrules the Trustee's objection.
Background
Ms. Church is a retired school teacher whose sole source of relevant income is retirement funds. According to the attachments to her 2016 tax return, her income in 2016 consisted exclusively of: (1) a distribution from her deceased husband's United Airlines Ground Employees' Retirement Plan in the amount of $2,933.16, from which $444.00 was withheld for federal taxes; (2) a distribution from the California State Teachers' Retirement System described as a "Retirement Annuity" in the amount of $2,838.80 from which $39.30 was withheld for federal taxes; and (3) a distribution from the California State Teachers' Retirement System described as "Service Retirement" in the amount $37,771.32 from which $4,864.80 was withheld for federal taxes and $1,084.11 was withheld for state taxes.
Ms. Church filed her chapter 7 Petition on December 31, 2016. By that date, all of the withholding for tax year 2016 had occurred, but a tax return for the 2016 tax year had not been filed. When subsequently filed, Ms. Church's 2016 tax return established that her withholdings exceeded her tax liability on both the federal and state level and, thus, that she was entitled to tax refunds. Ms. Church amended her schedules; she identified the refund amounts of $4,938 from her federal tax return and $1,026 from her state return, and she claimed an exemption of those amounts under section 22006 of the California Education Code ("EC").
The Trustee objected to her claim of exemption arguing, correctly, that EC § 22006 did not expressly extend to tax refunds and that tax refunds were not expressly exempt under California law. In response Ms. Church explained that all of her income came from exempt sources and specified that EC § 22006 or section 704.110 of the California Code of Civil Procedure ("CCP") provided a basis for her claim of exemption.
The Trustee did not and does not dispute that Debtor's income was exempt before payment to the taxing authorities; instead, she argues that the monies lost their exempt character as a result of those payments. Put another way, she argues that when Debtor received the refunds she received monies that were no longer exempt retirement funds.
The Court held a hearing and requested additional briefing. The Court then considered the parties' arguments, the briefs, and the authorities cited therein and determined that the Trustee's objections must be overruled.
Analysis
EC § 22006 provides:
The right of a person to an annuity or a retirement allowance, to the return of contributions, the annuity, or retirement allowance itself, any optional benefit, any other right or benefit accrued or accruing to any person under this part, and the moneys in the fund created under this part are not subject to execution or any
other process whatsoever, except to the extent permitted by Section 704.110 of the Code of Civil Procedure, and are unassignable except as specifically provided in this part.
CCP § 704.110 provides in relevant part:
(b) All amounts held, controlled, or in process of distribution by a public entity derived from contributions by the public entity or by an officer or employee of the public entity for public retirement benefit purposes, and all rights and benefits accrued or accruing to any person under a public retirement system, are exempt without making a claim.The Trustee never disputes that the income from Ms. Church's retirement funds would be exempt if paid to and retained by her. Rather, the Trustee argues that since neither EC § 22006 nor CCP § 704.110 specify that tax refunds are exempt, the refunds do not qualify for exemption.
(d) All amounts received by any person, a resident of the state, as a public retirement benefit or as a return of contributions and interest thereon from the United States or a public entity or from a public retirement system are exempt.
The Court is aware of five courts which have addressed the situation where admittedly exempt funds pass from the debtor to a state or federal tax authority and then return in whole or in part to the debtor. Three, In re Smith, In re Cook and In re Sparks, held that the refunds were exempt. Two, In re Annis and In re Hebert, held to the contrary. As discussed below, the result depends on whether the applicable state law provides for tracing of exempt funds.
In In re Smith, 401 B.R. 487 (B.A.P. 10th Cir. 2009), the Tenth Circuit Bankruptcy Appellate Panel relied on a ruling by the Utah Supreme Court (on certification) and held that exempt retirement income paid to and refunded by a taxing authority remained exempt. The Smith Panel summarized the Utah Supreme Court's ruling:
[T]he Utah Supreme Court recognized that, as a general rule, tax refunds are not exempt from a debtor's bankruptcy estate. In this case, it is undisputed that the retirement income from which Smith's taxes were withheld was exempt under Utah law. Utah's exemption statutes provide that certain classes of exempt property, including the retirement income at issue here, "remains exempt ... in any other form into which it is traceable" and recognize further that exempt property retains its
exempt character if the property can be traced by "any other reasonable basis for tracing selected by the individual."401 B.R. at 489-90 (footnotes omitted).
The Utah Supreme Court reasoned that by filling out tax forms for withholding of taxes and filling out forms to request a tax refund, the exempt funds can be reasonably traced since the amounts paid and received have been tracked throughout the process. "Thus, even though Ms. Smith's exempt retirement income may have been converted into taxes and then into a tax refund before being returned to her, it was reasonably traceable through the entire process and remains exempt [under the applicable Utah exemption statutes]." We agree that this result comports with the policy of construing exemption statutes liberally in favor of the debtor as articulated by Utah bankruptcy courts and state courts alike.
In In re Cook, 406 B.R. 770 (Bankr.S.D.Ohio 2009), an Ohio bankruptcy court held that under Ohio law a federal income tax refund, that the chapter 7 debtor received as result of over-withholding of otherwise exempt disability benefits, was exempt. The Cook court based its decision on Ohio state law that allowed tracing of exempt funds. Id. at 778.
The same result was reached by another Ohio bankruptcy court in In re Sparks, 410 B.R. 602 (Bankr.S.D.Ohio 2009). In Sparks, the court determined that an income tax refund directly traceable to otherwise exempt retirement benefits was exempt. As in Cook, the Sparks court based its decision on Ohio state law that allowed for tracing of exempt funds. Id. at 606.
The Tenth Circuit Bankruptcy Appellate Panel, in In re Hebert, 463 B.R. 142 (10th Cir. BAP 2011), reached a different result. It affirmed the bankruptcy court's order denying debtor's claimed exemptions in a federal tax refund attributable to withholdings from otherwise exempt unemployment compensation and retirement fund distributions. The Hebert Panel applied Wyoming law, which it distinguished from the Ohio and Utah law applied in Smith and Sparks:
Unfortunately for Debtor, Wyoming's Supreme Court has not recognized the tracing concept in case law as the Ohio Supreme Court has done. Nor do Wyoming's exemption statutes contain "tracing language" like the Utah statutes.Id.
The Trustee relies strongly on the only Circuit Court decision to address the issue, In re Annis, 232 F.3d 749 (10th Cir. 2000). In Annis, the Tenth Circuit applied Oklahoma law to hold that exempt money paid as taxes did not remain exempt when it was refunded because the originally withheld funds were taxes and lost their character as "earnings from personal services." Id. at 753. The Annis Panel noted that under Oklahoma's exemption statutes, once exempt property was converted to a different form, it lost its exempt status. Id. The Annis Panel did not discuss tracing, but it appears from the discussion that tracing was not available to that debtor or was not argued on her behalf.
So the question here is: what do the relevant California exemption statutes say about tracing? Fortunately for Ms. Church, the California exemption statutes provide for tracing.
California Code of Civil Procedure § 703.080, entitled "Tracing of Exempt Funds," provides:
(a) Subject to any limitation provided in the particular exemption, a fund that is exempt remains exempt to the extent that it can be traced into deposit accounts or in the form of cash or its equivalent.
(b) The exemption claimant has the burden of tracing an exempt fund.
(c) The tracing of exempt funds in a deposit account shall be by application of the lowest intermediate balance principle unless the exemption claimant or the judgment creditor shows that some other method of tracing would better serve the interests of justice and equity under the circumstances of the case.
In light of this provision, the Court is comfortable following the reasoning of the Sparks, Cook, and Smith decisions and determining that Ms. Church's tax refunds are exempt to the extent they are traceable to exempt funds.
This conclusion is not undercut by the Trustee's reliance on United States v. Bess, 357 U.S. 51, 55 (1958), and the assertion that federal law cannot be defeated by state exemption statutes. The Supreme Court in Bess determined an issue of federal tax law and held that while state law determined whether the taxpayer in that case had rights to property, the federal tax consequences were determined by federal law. Id. at 55. In our case the issue is whether Ms. Church can claim an exemption. And this is the critical distinction; as allowed by federal bankruptcy law, California opted out of the federal exemption scheme, so we look to state law to determine the scope of her exemption rights. See 11 U.S.C. § 522. Thus, federal law expressly provides that Ms. Church's exemptions arise under state law. The Trustee is incorrect when she relies on the supremacy clause and asserts that federal law trumps the state exemption scheme. Here, Ms. Church's right to an exemption is governed by federal law, but that federal law dictates that we look to the state law exemption scheme. There is no conflict between state and federal law in this case which would trigger a supremacy clause issue. Rather federal and state laws work in concert.
As a final matter, Ms. Church has the burden of tracing her exempt retirement income into her tax refunds. But in a case such as this, where all of the relevant taxable income was exempt, that burden is easily met - the undisputed record before the Court establishes that Debtor's sole income in 2016 was from exempt distributions from retirement accounts. As a result, it is beyond question that the tax refunds for the 2016 tax year are directly traceable to exempt assets. Exempt funds went to the taxing authorities, and a portion of these exempt funds were returned to Ms. Church. The Court determines that such a straight forward transaction qualifies for the tracing available under CCP § 703.080(a).
The Court, thus, holds that the exempt nature of Ms. Church's retirement distributions survived the trip through the IRS and FTB where, as is the case here, all of her income was exempt. The Trustee's objection is overruled, and the refunds are properly exempted. DATED: September 1, 2017
/s/_________
LAURA S. TAYLOR, Chief Judge
United States Bankruptcy Court In re Rita A. Church, Bk. No. 16-07962-LT7
CERTIFICATE OF MAILING
The undersigned, a regularly appointed and qualified employee in the office of the United States Bankruptcy Court for the Southern District of California, at San Diego, hereby certifies that a true copy of the attached document, to wit:
MEMORANDUM DECISION
was enclosed in a sealed envelope bearing the lawful frank of the bankruptcy judges and mailed via first class mail to the party at their respective address listed below: Daniel J. Winfree, Esq.
PO Box 19061
San Diego, CA 92159 United States Trustee
Office of the U.S. Trustee
880 Front Street, Suite 3230
San Diego, CA 92101 Eric Wolf, Esq.
P.O. Box 420448
San Diego, CA 92142 Rita A Church
6519 Bigby Lake Ave
PO Box 91147
San Diego, CA 92119 Nancy Wolf
P.O. Box 420448
San Diego, CA 92142
Said envelope(s) containing such document was deposited by me in the City of San Diego, in said District on September 1, 2017.
/s/_________
Regina A. Fabre/Judicial Assistant