Tax Refunds in Bankruptcy

17 Jan Tax Refunds in Bankruptcy

dreamstime_1773848Tax refunds are a primary vehicle for short term savings in many working class families.  The average tax refund is approximately $3000, a significant amount of money.  Bankruptcy can jeopardize the accumulation for one year or, in the case of a chapter 13 bankruptcy, can eliminate this fund from routine use for years.  How does this happen and why?

Tax refunds are a peculiar asset.  Because tax rates for individuals can vary dramatically due to the complex set of inclusions and deductions created by congress in the tax code, it is often difficult to predict the exact amount of tax that will be due for each taxpayer.  Compound this by adding mid year changes in the tax code or changes in a taxpayer’s circumstances and it becomes an ever more inexact projection. Tax tables provided by the IRS can only estimate tax for a family using the standard deduction.

Often, the tax refund has not been determined in amount even when the tax year has closed.  Third party payors and employers while required to send payment and withholding information to a taxpayer by January 31st, in some circumstances send the information months after the tax year has ended.  Pass through business entities, estates and trusts do not always file their returns and provide income and loss distribution information timely.  Tax return forms may not have been made available and may not be accepted for filing immediately.  Maddeningly, Congress has recently developed a habit of changing tax laws in December of the tax year or even as late as January or the following tax year; making the situation even more difficult.

Some lawyers and even some trustees do not understand that a refund or tax due can’t be definitively determined until the tax year has closed and the tax law covering that year has been finalized.

The problem in a Chapter 7 bankruptcy case comes from the failure of Congress to provide a specific exemption for tax refunds.  Some states may have an exemption that can be applied to all or part of the tax refund, such as earned income credit.  However, no dedicated federal exemption applies to tax refunds, other than the wildcard under 11 USC 522(d)(5).

Refunds to which no exemption applies can be claimed by the trustee as an asset that belongs to the bankruptcy estate.  The US Trustee even provides a form for use by the Chapter 7 Trustee in claiming the refund directly from the IRS.  Savvy bankruptcy lawyers carefully time the bankruptcy filing in order to minimize the risk that the debtor will lose a refund.  Unfortunately, some lawyers are not so savvy or circumstances may not permit a delay in filing the bankruptcy until the refund has been received and spent.  In these situations, only a wildcard exemption or a state specific exemption can preserve the refund for use by a debtor.  Not only will the non-exempt refund be taken by the trustee and paid out to creditors, the trustee will not give the money back if an audit results in a later adjustment that increases the tax due and negates the refund.

The Chapter 13 problem can be even greater than in a Chapter 7 case because there are multiple tax years involved; a minimum of three years of refunds will be at risk in a Chapter 13 and as many as five years or even more can come into play.  In some jurisdictions it is possible to budget a tax refund as part of the income required for necessary household expenses.

The Chapter 13 problem can be much more complex as it varies from court to court and a different result may even come from different trustees in the same court.  This is due, in part, to differing interpretations of 11 USC 1322(a) which requires that “a plan … shall provide for the submission of all or such portion of future earnings or other future income of the debtor to the supervision and control of the trustee as is necessary for the execution of the plan”.

Exempt or not, the Chapter 13 trustee may consider tax refunds as “future income” necessary for execution of the plan.  Unless the refunds were predicted and budgeted in the debtor’s schedules, the trustee could require these funds be paid over for distribution to creditors.

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I was admitted to practice in 1978. I am certified as a Consumer Bankruptcy Specialist by the American Board of Certification. I regularly speak on tax and bankruptcy issues at state, regional and national conferences. Years of experience in practice before the Internal Revenue Service and Oregon Department of Revenue have given me the background to resolve a large variety of consumer tax issues.
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