Income Tax Refunds in Bankruptcy-Chapter 7
If you’re filing a “straight bankruptcy” case, how do you keep your income tax refund?
Keeping tax refunds is all about timing. You can generally keep your refund but absolutely have to play it right, following rules that at first may not make sense. It is all too easy to mess this up, so you truly should have your attorney guide you through it, applying your unique circumstances to your local laws and practices. But here are the general principles at play.
Let’s start with some background to make sense of this:
- From the bankruptcy system’s perspective, a Chapter 7 case focuses on assets—determining whether you get to keep everything you own or not. That’s why it’s called the “liquidation” chapter. Most of the time you do get to keep everything, but sometimes some of it gets “liquated”—taken from you and turned by your bankruptcy trustee into cash, which then gets paid to your creditors.
- So where does your tax refund fit into this—is it is an asset that your trustee can take from you? That mostly depends on your timing.
- Everything you own or have a right to at the moment your Chapter 7 bankruptcy case is filed becomes your “bankruptcy estate.”
- That “estate” includes both your tangible assets and also intangible ones. One kind of intangible asset is a debt owed to you. A tax refund can be such an intangible asset of your “bankruptcy estate.”
The timing of the filing of your Chapter 7 case determines whether a tax refund is part of your “bankruptcy estate” and therefore could potentially be taken from you:
- An income tax refund is considered your asset as of the time of the last payroll withholding of the year being considered. That’s because as of that time, the full amount of that refund has accrued. Even though until you prepare your tax returns nobody knows the amount of your refund—or even whether you will be receiving one at all—for bankruptcy purposes, the anticipated tax refund is legally all yours as of the very beginning of the next year. And what’s yours is part of your “bankruptcy estate.”
- So IF you file after the beginning of the year but before receiving and appropriately spending the refund, that refund is part of your “bankruptcy estate” and is at least at risk of being taken from you. Again, this is true even if you have no idea how much that refund will be, or even whether you are entitled to one.
- BUT, if you DO receive and appropriately spend the refund before your Chapter 7 case is filed, then the refund is gone and is no longer your asset, and so is no longer part of your “bankruptcy estate.” Your trustee has no claim to it.
Even if your tax refund IS part of your “bankruptcy estate,” it will not be taken from you if it is exempt:
- Although theoretically it’s safest to file your Chapter 7 case when your tax refund is not part of your “estate”—such as after you receive and appropriately spend it beforehand, sometimes you don’t have that much flexibility about when you file your bankruptcy. Then especially it’s critical to get good legal advice about whether that refund will be exempt based on the local law applicable to the case.
- Usually, you get to keep most or all of your “estate” because it’s “exempt”—protected. In the same way, tax refunds are often exempt, depending on the amount of the refund and the exemption that’s applicable to it.
- Some states have specific exemptions applicable to certain parts of the tax refund, or laws that exclude them from the bankruptcy estate altogether, particularly for the Child Tax Credit or the Earned Income Tax Credit.
Even if a tax refund, or some portion of it, is not exempt, sometimes the Chapter 7 trustee may still NOT want it:
- The trustee may decide that the amount the “estate” would get—the refund by itself or in conjunction with any other non-exempt asset(s)—is not enough in value to justify creating an “asset case.” The amount of refund to be collected may be too small to justify the administrative cost involved to collect and distribute it. You might hear the trustee say that the amount of the refund is “insufficient for a meaningful distribution to the creditors.”
- What that “insufficient” amount is differs from one court to another, and often even from one trustee to another, so this is another specific area where you need the guidance of an experienced attorney.
- Caution: if the trustee is already collecting any other assets as part of the “estate,” then most likely he or she will want every dollar of your tax refunds that are not exempt.