Tax refunds in bankruptcy are a tricky issue. A tax refund is a valuable asset to you and your bankruptcy estate. Whether you get to keep your tax refund depends on what kind of bankruptcy you file (Chapter 7 or Chapter 13), the timing of your filing, and what state you live in. Careful planning must go into your bankruptcy filing in order to maximize the tax refund that you can keep. Discuss the issue carefully with an experienced attorney before filing your case.
Tax Refunds are Assets of the Bankruptcy Estate
There is nothing good about a tax refund. In the United States, we pay our taxes by having a portion taken out of each paycheck and paid over to the government all year long. Once a year, we file a tax return to tell the government how much we owed and how much we paid. If you are receiving a tax refund, it means that you overpaid your taxes and are entitled to get the excess back. A large refund means that you paid in a lot more than you needed to pay when you could have been keeping that extra money to live on.
A tax refund is property of the bankruptcy estate. This is true whether you have filed your return and are waiting to get the refund, or whether you have not yet filed your return, but have already overpaid what you owe.
Tax refunds are favorite assets for trustees to take because they are easy to recover. If the refund is still owed to you, the trustee can get the IRS to pay the money directly to them. The trustee can also get a court order that requires you to give them the refund when you get it, and they can prevent you from getting a discharge if you don’t give it to them.
Tax Refunds in Chapter 7
There are a few ways to protect a tax refund from being taken by the Chapter 7 trustee. First, your state may have an exemption that protects the refund. For example, many states have an exemption that covers Earned Income Credit. If part of your refund is made up of Earned Income Credit, you can exempt that portion of the refund and the trustee can’t take it. You may also be able to use a cash exemption or a wildcard exemption (that can be used on any property) to protect all, or a portion, from being taken by the trustee. If you can’t exempt all of it, the trustee may not take any of it if the non-exempt portion is small enough that the trustee doesn’t think there will be enough to make a meaningful payment to creditors.
Second, plan ahead. If you routinely received large tax refunds in the past, and expect to do so again, adjust your withholding so that less is taken out of your paycheck to minimize the amount of your refund. The smaller the refund, the less likely that a trustee will be interested in taking it, and the less that you have to try to exempt. The IRS website has a withholding calculator to help you figure out how much you should be withholding so you can make any needed adjustments.
Third, get your tax refund and spend it before you file your bankruptcy case. Make sure you spend it on necessary expenses, such as:
• Rent or mortgage payments
• Medical expenses (including glasses and contacts, braces and dentures)
• Car payments, maintenance and repairs
• Education expenses
• Attorney’s fees and costs for your bankruptcy filing
Do not pay family members or friends because the trustee could treat that as a preference or a fraudulent transfer and try to get the money back. Do not pay one credit card and not others or the trustee may be able to get that money back. Make sure to keep good records, including receipts, for how the money is spent.
Tax Refunds in Chapter 13
The bankruptcy code requires that all disposable income received during a Chapter 13 case be paid into the plan. Most Chapter 13 trustees treat a tax refund received during your case as extra disposable income since you could have received it during the year, but over-paid your tax obligation instead. A Chapter 13 case will last from 3 to 5 years. Each tax refund received during your case is subject to being paid into your plan. These refunds don’t count as plan payments and don’t shorten your plan. They are simply extra payments to your creditors.
You may be able to keep all or a portion of your tax refund if you have unforeseen circumstances or expenses that you need to use it for. Some examples are:
• Car repairs
• Replacement vehicles
• Emergency home repairs, appliance or furnace replacement
• Medical expenses
• Funeral expenses
If you need to keep your refund for these types of expenses, your attorney will need to file a motion with the court asking for permission to keep the funds. You may need to provide documentation, such as repair estimates or bills, to justify the need to keep the money.
A better option is to adjust your withholding before you file your case to minimize your refunds. Some jurisdictions allow you to keep up to a certain amount of your refund (check your local rules and practice), and if your refund is below that amount, you can keep it without having to file a motion.