Michigan Bankruptcy Blog

Pre-petition tax refund garnishment avoidable under 522(h), but not 522(f).

Johnson v CACH, LLC (In re Johnson), E.D. Mich., December 20, 2010 (Case No. 10-12873, Hon. Robert H. Cleland)

When a creditor has a state court judgment, garnishing the judgment debtor's state income tax refund is a common collection method.  If the judgment debtor files bankruptcy, issues often arise as to whether the creditor can keep the refund or whether the debtor is entitled to recover and exempt the refund.

In Johnson v CACH, LLC, the creditor had a pre-petition state court judgment against the debtor and obtained a writ of garnishment on the debtor's anticipated 2009 state income tax refund.  The creditor served the garnishment on the Michigan Department of Treasury in November of 2009.  On April 26, 2010, after the debtor filed her tax return, the Michigan Department of Treasury served notice of the garnishment on the debtor and the creditor.  The debtor had until May 10, 2010, to object to the garnishment, but she failed to do so.  Instead, the debtor filed a voluntary Chapter 7 petition on May 19, 2010.  The creditor received the tax refund on May 26, 2010.  The debtor filed a motion to recover the tax refund, which the bankruptcy court denied.  The debtor appealed to the district court.

The debtor argued that she was entitled to the tax refund for either of two reasons:

1. The tax garnishment was an avoidable judicial lien under § 522(f), or
2. The tax garnishment was a preference that the debtor could avoid under § 522(h).

The district court rejected the first argument.  Under § 522(f), the debtor may avoid the fixing of a lien to the extent that the lien impairs an exemption to which the debtor would have been entitled.  The court concluded that § 522(f) did not apply because the debtor could not have exempted the refund.  The debtor "lost all legal or equitable right" to the refund on May 10, 2010, when the time to object to the garnishment expired.  Consequently, when the debtor filed bankruptcy on May 19, she had no interest in the refund, so the refund was not property of her bankruptcy estate – and thus it could not be exempted.

However, the district court held that § 522(h) did apply.  Under § 522(h), the debtor may avoid a transfer of property if the property could have been exempted under § 522(g) and if the transfer would have been avoidable by the trustee but the trustee has not attempted to avoid the transfer.  § 522(g) provides that a debtor may exempt property recovered by the trustee if the transfer was not voluntary and if the debtor did not conceal the property.

Here, the court identified two distinct transfers.  The first transfer occurred when the garnishment was served (and thus perfected) in November of 2009.  The second transfer occurred on May 10, 2010, when the debtor lost all legal and equitable interest in the refund because she failed to timely object to the garnishment.  The court concluded the second transfer was an avoidable preference.  Accordingly, the court held that the debtor could avoid that transfer under § 522(h) and keep the tax refund.

Timing is key when a tax refund is garnished shortly before or after a bankruptcy filing.  Both debtors' and creditors' attorneys should review cases like Johnson and other tax refund cases (such as In re McCall-Pruitt, recently discussed on this blog post) to determine their clients' respective rights to a garnished refund.

Related Blog Post:

Did You Know? | Creditors have affirmative duty to release garnishments following bankruptcy filing.

Categories: Chapter 7, Eastern District of Michigan