Will My Chapter 7 Affect My Tax Refund? Part One
By Däna Wilkinson, Attorney at Law on Jun 1, 2007 in General Bankruptcy Information
One frequent topic of discussion with my clients is the way bankruptcy will affect their tax refunds. Some clients assume that all future refunds will somehow be set off against what they owe; others assume that the government will keep it for some period of time. I want to make sure that clients know what can happen to a tax refund, both to minimize the impact, and so my clients can plan accordingly.
When a Chapter 7 bankruptcy is filed, the court appoints a trustee whose job is to collect assets, turn them into cash, and use that to pay creditors. The pool of assets that can be reached by the trustee, called the “estate” is created on the day that the bankruptcy petition is filed with the court, and consists of everything the debtor owns as of that day. Bankruptcy courts have held that a tax refund, or a portion of it, can be an asset, even though you may not receive it (or even file your tax return) until well after the bankruptcy petition has been filed.
Most courts divide the tax refund in proportion to the point in the tax year when the case is filed. To make it simple, if you filed a bankruptcy petition on July 1, 2007, halfway through the year, 50% of your tax refund can become property of your bankruptcy estate. Obviously, if you file later in the year, that proportion will be greater. As another example, if you filed your petition in January of 2007, your entire tax refund for 2006 might become property of the bankruptcy estate. Note that I said “might”–there are other issues to consider, like any exemption you are entitled to claim, or whether your spouse has filed bankruptcy with you. The impact will depend upon those factors, and especially how you time your filing. And a little planning can go a long way.
Where I practice, in South Carolina, trustees will usually begin looking for tax refunds in cases filed in August, although it seems to get earlier every year. Trustees here are probably among the most aggressive on this issue, in large part because South Carolina has a very low cash exemption ($1,000, only available if you are not claiming a homestead) and does not recognize any other exemptions that affect tax refunds. Some states allow greater cash exemptions, or exempt the portion of the tax refund that is attributable to the earned income credit, so consulting with experienced bankruptcy counsel in your jurisdiction is a must.
Why do trustees start looking at refunds in cases filed in August or thereabouts? It’s purely a matter of practicality. The trustee is looking not just at the amount of the possible refund, but administering the case–tracking the filing of tax returns, making sure the refunds are collected. It also comes back to planning. I advise my clients who typically receive a large refund to review their W-4s, and if their large refunds are attributable to earned income credit, consider filing W-5s. A W-5 form is like a W-4, but calculates the likely earned income credit, and adjusts your withholding accordingly. I don’t recommend that clients claim more exemptions than they are entitled to, but if you claim what you are entitled to claim, you will take home more in each paycheck. Most people will still get a refund, but it won’t be as much.
Some clients are dismayed to learn that their tax refund might be taken by a trustee. I am in favor of planning to reduce the impact, but it shouldn’t drive the decision to file bankruptcy, or even determine when a bankruptcy is filed, unless there are no other factors to consider. Here’s why: First, if someone told you that you could take your tax refund and settle all your outstanding debt for that amount of money, would you take that deal? That’s essentially what you’re doing by filing bankruptcy. Second, most people in financial distress use their tax refunds to catch up on bills anyway. Again, bankruptcy will take care of that. (Many people go year after year, slowly falling behind on mortgages and other debts during the year, and using tax refunds to catch up again. It never occurs to them to modify their withholding, take home a larger paycheck, and keep it caught up during the year. And, by the way, avoid paying huge amounts of interest and late charges.)
Finally, because the bankruptcy estate includes only what the debtor owns at the time the case is filed, tax refunds for subsequent years are not affected by bankruptcy. Those will be yours to keep. Generally, Chapter 7 affects only refunds for the year in which the case is filed, but it can also affect refunds for prior years which haven’t been received prior to filing.
Each year, I see a lot of clients who end up using their tax refund to pay my fees and the costs of filing bankruptcy. Naturally, I am in favor of that, but it does seem to be a logical way to use those funds. But don’t wait to consult an attorney. There may be other issues which are more important, tax refunds may be exempt in your jurisdiction, or you may be able to set up your withholding to minimize the impact of bankruptcy on your tax refund.
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