Tax Season: How to Keep Your Pending Income Tax Refund While Starting a Chapter 13 Bankruptcy

Wasson and ThornhillChapter 13

You can usually spend your anticipated tax refund on something important, but may first have to get permission from the bankruptcy judge.

 

Received and Spent Tax Refunds

This blog post is about tax refunds that you are legally entitled to but have NOT yet received as of the time that your Chapter 13 case is filed. Under some circumstances the issues discussed in this blog post can be avoided if you wait to file your case until after you have already received and spent the refund. But this should only be done after getting advice of from a bankruptcy attorney.

Why?  Because the biggest single mistake made by people considering bankruptcy is to put off meeting with a bankruptcy attorney until after they have done something or failed to do something, which then often can’t be undone and significantly harms them. It may seem sensible to wait to see an attorney about filing bankruptcy when you think you are ready to file. But the reality is that often some of the most important advice you will get is about when you should file and actions you should or shouldn’t take during the time before filing.

Assets in Chapter 7 vs. Chapter 13

Our last blog was about how to keep a tax refund that you are entitled to but had not yet received at the time you file a Chapter 7 “straight bankruptcy” case.  To understand how this works under Chapter 13, let’s first quickly review how it does under Chapter 7.

The two issues under Chapter 7 are 1) whether that refund is an asset of your “bankruptcy estate,” so that the bankruptcy trustee potentially has power over it; and 2) if so, whether the refund is protected by a property exemption, which would then prevent the trustee from taking that refund.

As to the first issue, as of January 1 of each year the entire tax refund of the previous year is usually part of your “bankruptcy estate” and thus within reach of the Chapter 7 trustee.  That’s true even if the tax return for that refund has not yet been filed. In fact, even before January 1, during the tax year itself, the trustee may assert a right to a prorated portion of that year’s refund, especially late in the tax year when most of it has accrued.

As to the second issue, even if a pending tax refund is “property of the bankruptcy estate” and potentially within the reach of the Chapter 7 trustee, it is nevertheless often fully exempt—fully protected. If a tax refund is not protected by an exemption, the trustee would be able to take it from you.

Chapter 13, in a nutshell, goes through the same two-step process: whether the timing of the tax refund (in relation to the case filing date) puts it within the power of the trustee, and then if so whether the refund is exempt. If the refund is not fully exempt, then instead of paying it to the trustee, you generally just need to pay that non-exempt amount over time into your 3-to-5-year Chapter 13 case. That often gives you much greater control over where that money goes, such as to creditors you would want or need to be paid anyway.

Chapter 13’s Focus on Your Disposable Income

Beyond this focus on the pending tax refund as an asset, under Chapter 13 it is also considered part of your income since it would be arriving after your Chapter 13 case is filed.

Chapter 13 is designed for you to pay your creditors as much as you reasonably can over a 3-to-5-year period. So the money you receive from a tax refund shortly after the beginning of your case has to be accounted for—either earmarked for and spent on an explicitly designated and approved purpose, or paid to the Chapter 13 trustee to be distributed to creditors as your formal plan designates.

Getting Approval for Spending the Tax Refund on a Designated Purpose

You can get permission to use all or part of the refund on a specific very important expense. Your bankruptcy judge must be convinced of the importance of the expense, and that it should be paid through the money from the tax refund because it can’t be though your normal monthly budget. A common example of this kind of one-time expense is a vehicle repair needed so you can commute to work.

Putting the Tax Refund into Your Plan

If you don’t have a special expense that you can justify spending your tax refund on once it arrives, you would likely have to just pay it into your Chapter 13 plan. But that can often work out better than you expect. Your attorney can often draft your plan in such a way that the refund would go where you want it to go. 

For example, let’s say that you are behind on your child support and your ex-spouse is causing you grief because of it. Your Chapter 13 plan could be put together in such a way that most of your tax refund would go to catch up on that.