October Tax Season: What Happens to My Income Tax Refund If I File a Chapter 7 “Straight Bankruptcy” Case?–Part 2

Wasson and ThornhillIncome Taxes

Keep your refund if it’s small (enough) or by not filing bankruptcy until spending that refund (wisely).  

 

In our last blog post we described why income tax refunds are an issue in a Chapter 7 bankruptcy case, and how to protect a pending refund through exemptions, possibly through a “wildcard” exemption and, in some states, a special earned income tax credit one.

Pending Refund

A pending tax refund for bankruptcy purposes is one owed to you, and therefore is an asset that needs to be protected, and usually can be protected But it’s important to understand that a refund can be an asset in ways more broadly than you might think.

The most obvious is the tax refund that you are expecting because you have filed a tax return and know the amount of the refund you are expecting—either from the tax return or possibly after getting confirmation from the IRS and/or state about the amount that is going to be sent to you.

But a pending tax refund includes one that is owed to you even if you don’t know about it, or may be expecting or hoping for one but have no idea of the amount. The most common example is after December 31 of the tax year at issue has passed (at which point your refund is fully accumulated) but before your tax returns are prepared. At that point you may even think you owe taxes, but if you are actually owed a refund then that refund is part of your Chapter 7 case.

Odd as it may sound, even before the end of the tax year at issue, if you have a tax refund that WILL be paid to you after file your tax return on the following April 15, a PORTION of that current-year refund—the portion that has accrued to that point—may be treated as an asset for bankruptcy purposes. That is why some Chapter 7 trustees ask about this, especially late into the tax year when most of the refund has accrued, and especially with debtors who are expecting a relatively large refund making the trustee’s effort more worthwhile.

The point here is that tax refunds can usually be protected, but it’s important to know all that needs to be protected.

You Can Keep Your Tax Refund If It Is Too Small for the Trustee to Care

If your refund is relatively small—a few hundred dollars—the trustee may let you just keep it. Or if your refund is partially exempt and the part that is not exempt is relatively small, the trustee may let you keep that non-exempt portion.

Why would the trustee do this if he or she has the right to make you pay that money? Doesn’t the trustee have an obligation under bankruptcy law to your creditors to take all unprotected assets from you in order to pay them at least part of what they are owed?

Yes, the trustee has that obligation—that’s his or her main job. But a trustee CAN waive taking the refund by deciding that the amount of the refund would be “insufficient for a meaningful distribution to the creditors.” That’s a phrase you may hear from the trustee. It means is that, after taking out of the refund the trustee’s fee for his or her services, the work involved in splitting up the remaining amount among all the creditors would give them so little money that the effort is not worthwhile.

How much is too small for the trustee to bother with? It depends on the trustee, local practices, the number of your creditors and how much you owe them. Trustees are allowed to use some discretion about what they think is worthwhile. Their overseers—the local U.S. Trustee and bankruptcy judges—exert some influence on this discretion. Generally, the more creditors you have to split the tax refund money among and the more you owe them the lass likely the trustee will find that your refund will make “a meaningful distribution” to them.

Your attorney will be able to give you guidance on this, and can often predict which way the Chapter 7 trustee will go. But sometimes it’s a close call, made more difficult because you don’t know which particular trustee you’ll get and how that trustee will exercise his or her discretion.

By the way, it’s worth noting that the trustee will almost never let you keep even a small non-exempt tax refund if he or she is also collecting some other non-exempt asset(s) from you. That’s simply because then there’s no reason not to take the non-exempt refund from you. The trustee has already made the determination that it’s worth the trouble to collect and liquidate and distribute the other asset(s), that there IS going to be a “meaningful distribution” to the creditors. Adding the tax refund money only increases the amount being distributed, only makes that distribution that much more “meaningful.

You Can Protect a Tax Refund by Receiving and APPROPRIATELY Spending It

Because Chapter 7 involves only those assets which are legally considered yours at the moment your case is filed, if you wait to file until AFTER you have received and spent the refund money appropriately then that money is no longer yours. And so the received and spent refund is no longer an asset within the power of your bankruptcy trustee. Then you don’t have to think about whether the refund is exempt and protected because it’s not on the table as an asset at all.

We emphasize spending the money appropriately because the bankruptcy system looks very carefully (and suspiciously) at certain financial transactions done at the brink of filing bankruptcy. Talk with your attorney about your particular situation, but you will usually want to avoid situations in which you pay that money to a creditor, give it to somebody as a gift, use it to increase the value of something so that is already close to the exempt amount, or try to keep and hide it.

Certainly there will be situations where you won’t be able to wait until you receive and appropriately spend the refund. This will usually be because of pressure from creditors—lawsuits, garnishment, threats of vehicle repossession or home foreclosure, and such. But your attorney may be able to buy you more time with these until after you get and spend your refund. And there may be other significant advantages to delaying filing which you may not be aware of, which together with the tax refund advantage could make the delay highly worthwhile.

The bottom line is that often a judgment call needs to be made whether waiting for the tax refund is worthwhile. You can only make that judgment call if you have gotten good advice about all the advantages and disadvantages of that wait.