How Does Bankruptcy Affect Your Tax Refund?
How Does Bankruptcy Affect Your Tax Refund?
An important thing to consider when filing bankruptcy is how it will affect your tax refund. Will you be able to keep your tax refund? Or will you lose your tax refund to creditors? Knowing whether you expect to receive a tax refund or not and planning ahead, you can do things to ensure you can keep your tax refund. How bankruptcy affects your tax refund will depend on your strategic planning. Bankruptcy attorney, Stephen Trezza, at Arizona Law Group of Trezza & Associates will work with you to help you keep your tax refund, if at all possible and advisable.
Chapter 7 Bankruptcy and Your Tax Refund
When a person (debtor) files for Chapter 7 bankruptcy, generally, a tax refund becomes part of the person’s bankruptcy estate, along with all the person’s assets. It is highly likely you will be questioned about your tax refund by the trustee during your creditor’s meeting. The tax refund can be used to pay unsecured creditors.
Because you can keep any assets you receive after filing bankruptcy, a tax refund can be complicated. Often times, people apply for a tax refund before filing for bankruptcy but do not receive it until after they have filed the bankruptcy petition. The trustee will determine how to treat the tax return depending on when the income was earned that determined the tax refund.
IF the tax refund was or should have been received the year before bankruptcy
If the tax refund was not spent, it will be considered part of the bankruptcy estate, like other cash held by the debtor. The trustee typically will consider this tax refund the debtor’s money, because it is normally viewed as money unnecessarily paid to the federal or state government. This means it is treated just like other cash or money kept in the debtor’s bank account and used to pay unsecured creditors.
IF the tax refund was or should have been received the year of bankruptcy
The tax refund is prorated based on money earned before and after filing for bankruptcy. This means that the part of the refund attributed to income earned before the bankruptcy filing date will be considered as part of the bankruptcy estate. In other words, it will be considered as funds the trustee can use to pay unsecured creditors, just like cash or money in a bank account. However, the part of the refund attributed to income earned after the bankruptcy filing date can be kept by the debtor (person filing bankruptcy).
IF the tax refund(s) are received for tax year(s) after the year of bankruptcy
Since the refund(s) are based on income earned after the bankruptcy filing date, the debtor can keep the full amount of the refund.
Keeping Your Tax Return with Strategic Planning
You can keep your tax refund received on money earned before filing bankruptcy with some strategic planning. Time your bankruptcy filing and receipt of your tax refund well, and you can keep the money. Don’t and the refund will become part of your bankruptcy estate used to pay unsecured creditors.
If you plan your bankruptcy filing in advance, there are some things you can do to protect your tax refund from being taking by the creditors either by:
Decreasing the amount of withholding from your paycheck to offset any refund you would have received, so you receive the extra money back in your paycheck rather than needing to wait for the tax refund; or
Filing your taxes early and using the refund for necessary expenses; or
Requesting the tax refund be included in your bankruptcy exemptions.
Planning to File Bankruptcy within a Year
If you are planning to file bankruptcy within a year, the easiest way to avoid an issue with your tax refund is by adjusting your withholding from your paycheck, so that you only pay the amount of tax you owe. This means you will get more back in your paycheck. If planned accordingly, your refund will be too insignificant to provide any meaningful payment to creditors. At times, if the refund is small, the trustee may abandon it, allowing you to keep the refund. However, you want to make sure that you continue to withhold enough to offset your tax liability.
Receiving a Tax Refund before Your Bankruptcy Filing Date
If you receive your tax refund before your bankruptcy filing date and want to keep it out of the bankruptcy estate, spend it. Money you no longer have can be included in your bankruptcy estate. So, make sure you spend it on permissible expenses.
Approved expenses include:
Housing expenses, including: mortgage, rent, repairs, and utilities;
Food and clothing;
Car payments and repairs; or
Unapproved expenses include:
Repayment of any one credit card;
Indulgent expenses; or
Payments or gifts to family members or friends.
If you spend it, make sure you keep detailed records and receipts of your purchase(s). If you pay off one creditor and not others, the trustee could determine you favored one creditor over the others and force the creditor to return the funds received to the bankruptcy estate. Also, if you used the money for indulgent gifts or expenses, the trustee could refuse your discharge, if they find you acted in bad faith. Therefore, make sure you use your tax return on permissible expenses and maintain adequate records.
Receiving a Tax Refund after Your Bankruptcy Filing Date
If you receive a tax refund after you file the petition for bankruptcy, the part of the refund that is based on your income you earned before the petition was filed will become part of the bankruptcy estate. However, you may be able to keep it. Certain property is exempt. For example, in Arizona $300 in a bank account can be exempted, as well as, a percentage of the debtor’s disposable earnings.
Chapter 13 Bankruptcy and Your Tax Refund
When debtors file Chapter 13, all disposable income is paid into the plan and used by the trustee to offset plan expenses. Only regular income, not considered disposable, is the income used to establish and make plan payments and pay reasonable expenses, such as: housing, food, and transportation. Tax refunds are considered disposable income and, typically, must be paid into the plan.
Because tax refunds are considered an indeterminable amount, they are not used to establish your payment plan. However, the trustee will view tax refunds as excess income that must be paid into the plan. The trustee will consider you having enough money to pay for your necessary expenses and plan payment out of your regular income. If you do not have enough regular income to pay for necessary expenses and make the plan payment, the trustee, generally, will determine the plan is not working. However, there are ways to exempt your tax refunds, as long as, you have a strong argument for using them for permissible expenses that were not included in your budget or need them in order to make your plan work. It’s important to speak with an experienced bankruptcy attorney to determine what expenses your tax refund may be used to pay and to ensure proper documentation of the expenses has been maintained.
Modifying Your Payment Plan to Exclude Your Tax Refund
Filing a plan modification will allow you to request the court to exclude your current tax refund. You must file a modification for each year you have a tax refund you want excluded. For the modification to be complete, you must:
Specify which tax refund you are requesting to be excluded;
Amount of the tax refund received; and
Explicit details why you need to keep the tax refund.
Also, you must keep receipts for how you spent the money or documentation for how you plan to spend the money.
The court will not exclude tax refunds for expected expenses that are necessary and included in your budget, as your normal income should cover these planned costs. If you need the tax refund to pay for these planned expenses, it is a red flag that you have not followed the budget, or the Chapter 13 payment plan is not working. However, you can argue you need the tax refund for unexpected expenses, such as:
Replace a broken appliance;
Unexpected medical costs for you or your dependents; or
Other unexpected expenses, e.g., funeral costs, etc.
Including Plan Language to Exclude All Tax Refunds
Unlike the modification that must be filed with the court for each tax refund, you can include language in the plan to exclude all tax refunds received during the plan, arguing you need the tax refunds to make the plan work. Usually, trustees and creditors will object to a broad exclusion of tax refunds from the plan. In order for the judge to grant the request, you will need to argue that you need the tax refunds to pay permissible and necessary expenses. Therefore, you will need to include the tax refunds in your income and budget.
Since you cannot rely on how much your tax refund will be to pay your bills, as you may not even receive one, the court may decide Chapter 13 is not a good fit and feasible plan for you. Although this can seem like a simpler method, it can be complicated and needs to be handled delicately. Depending on your individual situation, it may reap better results to file a modification rather than a plan exclusion.
Excluding Your First Tax Refund under Chapter 13
The best way to exclude your first tax refund is to plan your Chapter 13 bankruptcy filing, giving yourself time to collect and spend your tax refund. Make sure to talk to an experienced bankruptcy attorney, as you are only allowed to spend your tax refund on certain, permissible expenses. If you spend it on other expenses, it can cause additional problems including not being permitted to file Chapter 13 or considered having acted in bad faith. However, the best way to ensure you do not have to include your first tax refund under Chapter 13 is to spend it.
Also, if you typically receive large tax refunds, before you file Chapter 13, you should consider changing your tax withholdings, so you will receive more money in your paycheck. Although this money will give you more to pay plan expenses, your attorney can also use this money to find additional monthly expenses. Just make sure you continue to have enough withheld to pay your taxes. You want to keep your tax refund minimal but not add to your financial troubles by creating a tax bill and underpayment penalties.
Including Your Tax Refunds in Your Chapter 13 Plan Can Have Unexpected Benefits
You would do yourself a disservice not to consider the benefits of willfully paying your tax refunds into your Chapter 13 payment plan. Since tax refunds are considered disposable income, they will be considered payable into the Chapter 13 payment plan. However, the tax refunds, typically, are not considered in determining the amount of your monthly payments, as tax refunds are normally indeterminable. It can help you at least adhere to your plan, and at best, it can help you payoff your plan earlier. The tax refunds can help reduce the amount of your monthly payments, making the plan more realistic. Or, they can be used to reduce the number of monthly payments you have, helping you finish the process that much sooner.
Contact Arizona Law Group of Trezza & Associaties for a free, no-obligation consultation to receive advice regarding the best bankruptcy plan for you to file and how to exclude your tax refund, if possible and advisable. Tuscon bankruptcy attorney, Stephen Trezza, has been helping families achieve financial freedom for over 25 years.