Debtor’s Exemption in Adoption Tax Credit Properly Claimed Under Illinois Law as Public Assistance Benefit

Ruling on an issue of first impression in Illinois, the Bankruptcy Court for the Northern District of Illinois reversed its prior ruling to conclude that a debtor’s claimed exemption in an adoption tax credit was properly claimed.

This case is interesting because it draws a distinction between a regular “tax credit,” which in bankruptcy would likely be considered an asset, versus the “tax credit” at issue in this case – that is, a credit designed to provide a certain type of financial incentive in adoptions.

As a result of this, the Court deemed the tax credit to be a public assistance benefit, fully exempt under the Illinois exemption laws.

Following is a quick summary of the case.

In Johnson, a debtor had adopted 2 children with special needs in 2011. [FN1] She subsequently filed a chapter 7 bankruptcy case pro se. In her case, she scheduled an anticipated adoption tax credit in the amount of $26,760, and claimed the full amount as exempt.

The trustee objected to the exemption on the basis of the language of the Illinois exemption statute, which granted an exemption for a debtor’s right to receive “a social security benefit, unemployment compensation, or a public assistance benefit.” [FN2] He took the position that while the credit was intended to induce socially desirable behavior, the tax credit could not be construed as a “public assistance benefit.” The Court sustained the objection and entered an order disallowing the exemption.

The debtor subsequently retained counsel who prepared amended schedules which claimed the prorated refundable portion of the tax credit based on the debtor’s 2011 income ($23,206.14) as fully exempt and filed a motion to vacate the Court’s order. The debtor, with the assistance of new counsel, argued that the tax credit not only furthered desirable social action but helped those in economic need.

The Court noted that the term “public assistance benefit” as used in the Illinois statute is not defined under Illinois law. [FN3] Finding the statute open to two different interpretations, the Court then carefully considered the purpose and policy of the credit, as established by its legislative history.

The adoption tax credit was initially created by the Small Business Job Protection Act of 1996 (“SBJPA”) signed into law by President Clinton. The SBJPA amended the IRC to provide for a nonrefundable income tax credit for certain qualified adoption credits. The applicable law has further been amended since then to increase the available credit amount, and also, in 2010 and 2011, to become fully refundable to the tax payer.

The Court found that the purpose of the adoption tax credit was to encourage the adoption of special needs children and defray adoption costs.  It found that it was designed not only to induce socially desirable behavior, but also provide a financial incentive designed to defray the high costs associated with the adoption process, including the suggestion that the credit was especially enacted to benefit adoptive parents with moderate incomes. [FN4]

The Court noted that the key factor in this case was the refundable nature of the tax credit. A refundable tax credit, like a payment, can be refunded to the taxpayer by the Internal Revenue Service. In contrast, it noted that a nonrefundable tax credit is a credit that can reduce income tax liability to zero, but any remaining credits are not refunded to the taxpayer. [FN5]

Being mindful of the Seventh Circuit’s instruction that an exemption statute should be liberally construed in favor of the debtor, because the adoption tax credit in this case was fully refundable in 2011, the Court found that it may be claimed exempt as a “public assistance benefit” under the Illinois statute providing for the exemption. [FN6]

[FN1] In re Nekessa Danyelle Johnson, 480 B.R. 305, 2012 WL 4829329, Bankr. No. 11 B 45378 (Bankr. N.D. Ill. October 11, 2012) (Baer, J.).

[FN2] 735 ILCS 5/12-1001(g)(1).

[FN3] Johnson, 2012 WL 4829329 at *4 (citing In re Koch, 299 B.R. 523, 525 n.5 (Bankr. C. D. Ill. 2003); In re Fish, 224 B.R. 82, 83 (Bankr. S.D. Ill. 1998)).

[FN4] Id. at *8.

[FN5] Id. (citing Koch, 299 B.R. at 527-28).

[FN6] Id. at *9.

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