As tax season approaches, it’s a good time to talk about how (or whether) bankruptcy will affect your tax refund. A previous post dealt with how Chapter 7 might affect your tax refund; now let’s talk about how you tax refund will be treated in, and will affect, your Chapter 13 bankruptcy.
Unlike a Chapter 7, we are not looking for assets to seize to pay your creditors in a Chapter 13. A Chapter 13 is a payment plan. Nevertheless, the amount of your tax refund, and whether you can claim it as exempt, can affect your Chapter 13 Plan. In order to make sure that your Chapter 13 plan is fair to your creditors, the bankruptcy court and the Chapter 13 trustee look at two factors. Well, they look at more than that, but these two are the most important: the “income test,” and the “equity test.” Put simply, the income test means that you are paying all you can afford to pay to your creditors. The equity test means that you are required to pay your creditors, over time, at least as much as they would receive in a liquidation. Your tax refund can affect both of those.
Let’s talk about how your tax refund can affect the equity test. If you can claim your tax refund as exempt (exempt property is property you are entitled to keep regardless of the claims of your creditors or bankruptcy trustee) then your tax refund won’t affect the equity test at all. On the other hand, if your state does not allow you to claim your tax refund as exempt, it will be added to other non-exempt assets to come up with a floor, or a minimum amount that you must pay your unsecured creditors over time. So, let’s say that you have exempted all the property you can, and there is still $1000 in your bank account and a tax refund of $2000 left over that is “non-exempt property” in bankruptcy parlance. In that case, the Court would require your Chapter 13 plan to pay at least $3000 to unsecured creditors, over the life of your plan. Now, if you wanted to, you could simply pay your tax refund to your Chapter 13 trustee in order to keep your monthly payments affordable. Some trustees might prefer that, and you might think that it would be better to get a little ahead in that way. In my view, it depends on the client and the situation. I look at several factors, including whether my client has any other nest egg that can be used in the event of an emergency, which creditors are in line for immediate payment, and the client’s track record in budgeting and dealing with financial pressure.
One of the complicating factors in dealing with tax refunds in Chapter 13 is that they count as income, too. In a Chapter 13 case, when the court and the trustee look at your budget, they don’t just look at your net check every payday; they look at what you get at tax time, and add that back to your income. So, if your average take-home pay is $4000 per month, but you get a tax refund of $6000 every year, in the trustee’s mind your take-home is $4500 a month.
But, you say, I don’t get that every month!! How can I make a payment based on that amount? There are two ways to do that. One is to pay your tax refund to the trustee each year during your Chapter 13 case. That eliminates the need for re-aligning your budget to account for that amount. The other is to adjust your withholding so that you have that money in your paycheck, rather than waiting until the end of the year to get it back.
Again, which of those choices is the best on depends in large part on the individual client and his situation. If the client’s income is low, or sporadic, and the refund high, it may be impossible as a practical matter to work that into the budget. On the other hand, if the client has no nest-egg to fall back on in an emergency, she may prefer to squeeze the budget a little. In either case, my advice is to adjust withholding so you have more in your paycheck, and less you’ve loaned to the government. Now, don’t go getting all crazy with that—there are plenty of official and unofficial withholding calculators that will help you reduce your withholding without ending up owing taxes.
Once again, I have answered a bankruptcy questions with “it depends.” You may indeed get to “keep” your tax refund in a Chapter 13 bankruptcy, in the sense that you may not have to turn it over to your trustee. But, in the sense that it all goes into your budget and your budget determines what you pay to your trustee, well, it all comes down to the same thing, doesn’t it?