Wanted-Exemption for Earned Income Credit

The earned income credit, created by 26 U.S.C. §32 (1994), is a refundable tax credit provided for low income workers who have dependent children and who maintain a household. The earned income credit is paid as a tax refund. In other words, if the earned income credit exceeds a person’s tax liability, the excess amount is considered an ‘overpayment’ and is refunded. So, low to middle income workers with children can get a tax “refund” that is more than was withheld from their paychecks. It is designed to make it more beneficial to work than to subsist on public assistance. And since it is a form of public assistance, we the taxpayers fund it.

Unfortunately, when a low income individual files Chapter 7 bankruptcy, especially about this time of year, that earned income credit is often taken by the Chapter 7 trustee. For most debtors who receive a substantial tax refund the earned income credit is a large part of that refund, and as noted above, can actually exceed the amount of taxes withheld.

For ordinary people, a tax refund can make a big difference in their financial lives. It can buy basic transportation, or a new furnace. It may be the only “savings” a family has. In the administration of a bankruptcy case, however, it might not amount to much. I reviewed a final report in one of my cases where the only asset was a tax refund, which was largely due to the earned income credit. The trustee in the case received about $2800. The trustee’s commission and fees to his law firm were about $1,000. Ultimately, the trustee paid a dividend of 1.84% to unsecured creditors. And if the truth were known, it probably cost the federal government more than the total amount distributed to maintain the court and other personnel to administer the case and audit the trustee’s books.

The earned income credit is exempt under the laws of a handful of states, but there is no federal exemption that preserves the earned income benefit for the people it was intended to assist. In South Carolina, where I practice, the Bankruptcy Court has found that the South Carolina statute exempting “public assistance” from the claims of creditors and bankruptcy trustees does not extend to the earned income credit. So, we have a tax credit funded by taxpayers, but no way to preserve the benefit for those who need it.

I read with interest Kent Anderson’s post about the seizure of an earned income credit to pay a student loan. That offers yet another reason to add a federal exemption provision to protect the earned income credit from the claims of creditors.

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