When you file a bankruptcy, your tax refund is an asset of your bankruptcy estate. Your tax refund may include an earned income credit (EIC). When it does, you could have a big refund coming to you.
Whether your trustee (the person appointed by the court to find assets that can be converted to cash to pay your creditors) can take your EIC depends on the exemption laws in your state and what chapter you file. If your exemptions cover your EIC and are properly taken in your case, then the trustee can’t take your EIC in a Chapter 7, but that may not be the case in a Chapter 13.
Tax Refunds and the Bankruptcy Estate?
A tax refund represents a repayment to you because you had too much tax taken out of your pay check during the prior year. A tax refund can also include credits, which are benefits that the government has decided to give by reducing the amount of tax that you owe. An EIC is a credit given to working parents with low wages and is essentially a type of welfare payment. Getting an EIC can result in very large tax refunds.
All tax refunds are property of the bankruptcy estate, whether the refund has been received or not. A tax refund is an easy asset for a trustee to take because they can actually direct the IRS to pay them instead of you, which makes it easy for the trustee to get the money.
Exempting Your EIC
You can protect your tax refund and your EIC if you have an exemption available. Federal and state laws allow debtors to exempt certain property that is deemed necessary to get a fresh start. Some states use federal exemptions and some states have their own exemptions. Which you use will depend on what state you live in and how long you have lived there. It is important to discuss this carefully with your attorney.
If your state has an EIC exemption, you can protect the whole amount of your EIC, whether it has been received or not. If your state doesn’t have an EIC exemption, you may be able to use a wildcard exemption (that can apply to any property), or a cash exemption to protect your EIC. Make sure that you list the EIC as a separate asset in your bankruptcy papers and take as much exemption as possible.
If your EIC is more than your available exemption, then you may lose a part of your EIC. Talk with your attorney before filing your case to see if you have other options.
Other Options to Protect Your EIC In Chapter 7
If your state doesn’t have an EIC exemption, then you may be able to adjust your withholding during the year to minimize the amount of your tax refund. You want as small a refund as possible so that other exemptions you have available can be used to protect at least a portion of your EIC. If you are over-withholding and get that corrected, you will actually get more money in your pay check to live on.
Another option is to wait until you receive your refund and spend it down before you file your bankruptcy case. You can spend it on regular living expenses like rent, utilities, food, clothing, medical expenses, insurance, and car repairs. Do not purchase luxury items, make payments to family members or friends, or pay off unsecured debt, or the trustee may ask for the money back. Ideally, you want to have as little of the refund left when you file as possible. The trustee can’t take it if you don’t have it and it has been properly spent down. You will want to consult an experienced attorney to help you decide the best option for you.
EIC In Chapter 13
When you file Chapter 13, an EIC is still considered an asset of your bankruptcy estate and the guidelines above apply. This would allow you to protect an EIC that you have earned, but not yet received when your case is filed. However, if you expect to receive an EIC each year that you are in your plan, you may not be able to protect those funds later in your case.
A Chapter 13 lasts from 3 to 5 years. In a Chapter 13, all disposable income received during your case must be paid into the plan. Each tax refund that you get during your case is considered by most courts and trustees as disposable income to be paid into your plan, including the portion that may be from an EIC. The exemption for an EIC doesn’t apply to an EIC that you get after your case is filed.
Protecting an EIC for those years after a Chapter 13 is filed, and while the Chapter 13 is pending, depends on careful planning to adjust your withholding so that some of your EIC could be used to cover your regular tax liability. This could end up giving you extra money in your paycheck to live on.
You can also file a motion with the court when you get your EIC asking for permission to keep the funds for unanticipated expenses such as car repairs, medical expenses, emergency home repairs and replacement vehicles. It is important to talk with your attorney about what you can do to keep as much of your EIC as possible during your case, or at least be prepared and plan for the possibility that you may not have those funds available to you.