Income Tax Refunds and Bankruptcy

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By Susan K. Duke, Esq.  

Duke Law Firm, P.C.,Lakeville, NY

Many taxpayers view their income tax refunds as a yearly bonus. While in reality these refunds are usually caused by the taxpayer having too much taxes deducted from their paychecks, most view these refunds as found money rather than their own money held by the taxing authority. Many have even come to rely upon these refunds for planned yearly spending to catch up on bills, go on vacation, buy necessities, etc. Because of this reliance upon income tax refunds, debtors filing for bankruptcy are often dismayed to find that the bankruptcy court may seize part or all of their refunds. How might this be avoided?

The first thing the debtor must understand is the idea of the "bankruptcy estate." Every asset the debtor has, or has the right to receive, at the time they file their bankruptcy petition is considered a part of the bankruptcy estate. Every asset, to the extent not considered exempt, is subject to being taken by the bankruptcy trustee to distribute to the debtor's creditors. Avoiding this taking of assets is one of the goals of the debtor, and a goal an experienced bankruptcy attorney can help a debtor achieve.

The best way to avoid loss of the refund is bankruptcy planning. A number of things can be done to avoid losing any of the refund if the debtor is able to plan ahead. The first thing the debtor may do is to change their allowances on their W-4 form. Instead of just reporting one allowance for a single debtor without dependents, for example, the debtor may wish to list two or three so that they lower their withholding and therefore lower the amount of expected income tax refund. The debtor may modify their W-4 form and submit to their employer or payroll department at any time, immediately adjusting the amount of tax withheld from their paycheck. The debtor is then left with more spending money throughout the year, and there is nothing left for the court to take when the debtor files for bankruptcy.

One note of caution, however; a debtor should not artificially reduce their claimed allowances in an attempt to reduce their take-home pay and avoid a possible Chapter 13 bankruptcy.  Debtors who receive exorbitant income tax refunds or report little net income despite having substantial gross income may be requested to convert a Chapter 7 filing to a 13 or face a substantial abuse application by the trustee. If the debtor is otherwise capable of funding a Chapter 13 Plan and paying back part or all of their debts, they are expected to do so and cannot escape in a Chapter 7 by claiming too few allowances on their W-4 form.

Another possibility to avoid the taking of the refund is to receive and spend it prior to the filing of the bankruptcy. Generally speaking, utilizing the refund to pay necessities such as rent, vehicle loan, mortgage payment, food, clothing, and utilities will protect the refund from being taken by the bankruptcy trustee.  These expenditures will be examined by the trustee to be sure they are necessary. The safest way for a debtor to account for the expenditures is to deposit the refund in an account containing no funds other than the refund, and to pay all expenses by check or other method that allows the debtor to easily prove the payment. If the debtor deposits their refund into an account containing other monies such as their weekly pay, and that account is then used to make both necessary and unnecessary expenditures, it will not be clear that all of the refund monies were properly spent. Commingling of the refund makes it impossible to know what money went where. Attorneys and debtors should also use caution as each trustee is different on their policy as to what spending of the refund is considered permissible. For instance, most but not all trustees will allow a debtor to purchase and retain an exempt, necessary asset with their refund, such as a vehicle. Prior to advising the debtor to spend their refund, the attorney should be aware of customary practice in their local court.

The other way to protect refunds is to plan the timing of the filing of the bankruptcy. Even if the debtor receives and spends their refund prior to filing, the trustee may assert a claim to the next year's refund. Whether the bankruptcy trustee may take part or all of the debtor's refund depends upon the time of the year the bankruptcy is filed. If the bankruptcy is filed prior to January 1st, the trustee may take the pro rata portion of the refund attributable to the months prior to the filing.  In other words, if the petition is filed on June 30th, six months of the year is considered to be pre-petition and a part of the bankruptcy estate. The trustee may take 50% of the debtor's refund in this example.

These options do not apply to all debtors.  Chapter 13 debtors, for example, are usually expected to contribute their refunds to their bankruptcy plan payments. Even if the debtor modifies their paycheck deductions, the extra income retained will be applied to plan payments. However, if the debtor is able to satisfy most or all of their debts through their Chapter 13 Plan without contribution of the refund, the debtor will likely able to retain the refund. 

The bankruptcy attorney needs to be aware of how their local Chapter 13 trustee will handle income tax refunds so that they may warn their clients ahead of time whether or not they will be able to rely upon the refund for unexpected expenditures outside their plan.

Also, a debtor may not have timing options, facing foreclosure, wage garnishment, or other adverse collection activity, and may need to file bankruptcy immediately. Additionally, many debtors will be able to claim part or all of their refund as exempt under available Federal or State exemptions, and thus retaining the refund without any planning.

Debtors also need to be aware that the trustee, regardless of any planning or exemption available, might not seize part of their refund. For instance, in some jurisdictions, refunds attributable to the Earned Income Credit are never considered part of the bankruptcy estate and thus may not be seized by the bankruptcy trustee. Additionally, if a married debtor files an individual bankruptcy petition, only the refund attributable to the debtor's pro rata share of the income reported on the joint tax return is subject to seizure by the bankruptcy trustee.

Many debtors, especially those who live in states where they are able to utilize federal exemptions, will be able to retain their entire refund, no matter when received. Those without homes are most likely to be able to retain their entire income tax refund through the Federal "wildcard" exemption. If the debtor does not claim any equity in a home, the debtor then has available to them an exemption currently worth $11,975 ($10,825 of unused homestead exemption and $1,150 wildcard) that may be applied to retain any property of theirs that would otherwise be non-exempt. Assuming the debtors have little or no other property for which they need to apply the wildcard exemption, they then would be able to retain any income tax refunds received under $12,000. Debtors utilizing the homestead exemption have only $1,150 available to apply to income tax refunds or additional otherwise non-exempt property.

Debtors who must utilize a homestead exemption may be able to retain more of their refund through available state exemptions. Many states offer a wildcard and wages exemption, which may mean more to the debtor than the $1,150 federal wildcard exemption.

With a little planning and knowledge of bankruptcy procedure, the debtor should be able to retain most or all of their refund. It is up to the bankruptcy attorney to properly direct their client so they do not lose their expected "bonus" at tax time.

For more information, in the Tax Management Portfolios, see Mather and Weisman, 638 T.M., Federal Tax Collection Procedure - Defensive Measures, and in Tax Practice Series, see ¶3885, Bankruptcy - Tax Collection Issues.