WHAT HAPPENS TO MY TAX REFUND IF I FILE BANKRUPTCY?

Those caught between the pinch of filing income tax form timely as well as dealing with a bankruptcy definitely can claim the title of being stuck between a “rock and a hard place.” The most common question that comes up in these situations tends to revolve around what happens with a tax refund if one is due based on the filings for the previous year.

Normally, a California bankruptcy is filed in Federal court with some California rules applied, meaning ones entire financial picture has to be reorganized and cleared. Note that when a person files for bankruptcy it is not a free pass to stop paying one’s debts. Instead, the filer is literally turning over a personal financial situation to the court to resolve, typically assigned by the process to a court trustee. The trustee’s job is to go through everything, including all the debt, income, assets and potential resources and resolves the matter, with as much debt paid down as possible before the person is cleared of any further responsibility. The debtors, those who are owed, are prioritized in categories of debt type, usually with collateral holders taking the highest rank and revolving debt like credit cards taking the lowest in the pecking order. Since there’s not enough to go around in most cases, the lower ranked debtors usually get little or nothing of a distribution, but it depends always on what the court makes as a final decision.

Tax refunds are in essence money due to the estate from income overpayments. That kind of money is free and clear and one of the most liquid assets or accounts receivable held by a filer. So, the trustee almost always will grab any tax refund balance due as part of the case package. While there are some exemption state laws in play, most cash amounts or interests are grabbed and confiscated by the trustee.

Chapter 13 Bankruptcy and a Tax Refund

In the case of a Chapter 13 filing, the party going bankruptcy is not asking to waive outstanding debt entirely but to reorganize it. That may mean smaller payments as well as lower interest or the debt extended over a longer period. The court and trustee will determine exactly what and how one’s debt can be re-planned, and then the filer agrees to the plan and exits bankruptcy status. The filer is then responsible to follow the plan.

Where a tax refund enters the picture, it is possible to request that a Chapter 13 reorganization plan exempts it. However, trustees will likely argue against such a waiver, see the money free and clear and ready to remove outstanding debt. Very few are able to successfully keep a tax refund, even if expecting to use it for basic living costs.

Chapter 7 Bankruptcy and A Tax Refund

In the case of a Chapter 7 filing, the filer is basically testifying to the court they are in over their head and there is nothing that can be done aside from paying off as much as possible and then clearing the slate. Then take control of everything, pay of debtors and resolve outstanding assets and liabilities.

In the case of a tax refund, whether due prior to or during the bankruptcy, it is pretty much going to be grabbed by the court and used to pay down debt where possible. The trustee will typically look at the tax returns from a year before, anticipate the tax refund likely, and may expect the filer to pay an estimated amount as well if nothing has changed.

Common Mistakes People Make about Tax Refunds

Some like to think that a tax refund filed and due after filing bankruptcy somehow is free and clear of the bankruptcy filing. This is false and a myth. The trustee has the ability to seize any cash due as well as any payments made to others just before filing bankruptcy, up to six months prior or longer. This is a common tactic by some who file after hiding assets with a friend or relative, hoping to avoid the trustee’s seizures. It usually doesn’t work and it would be a crime as the filer would then technically be lying to a federal court, which is a serious federal felony. So, don’t do it. Until your filing is cleared, all incoming assets and cash due are under the trustee’s power.

Exceptions That Might Work

There are exceptions on a tax refund spent right before filing for bankruptcy. These generally include household necessary expenses such as rent, mortgage payments, food, necessary clothing, medical costs, home repairs, utilities, education, and necessary insurance, as well as car repairs. This at least gets the benefit of the tax refund on your direct needs versus no benefit at all and entirely going to a debtor per the trustee.

Alternatively, avoiding a tax refund completely is a better way to go. If you are pretty sure you will be filing within a year, adjust your tax withholding with work as much as possible to pay the least amount possible. This will likely result in some taxes owed at the end of the year, but you won’t have any tax refund to hand over or have to explain where it went.

You can schedule a free consultation with one of the knowledgeable bankruptcy lawyers at Berneman Law Firm. Just call 888-200-4443 or fill out the contact form on this site.