October Tax Season: What Happens to My Income Tax Refund If I File a Chapter 7 “Straight Bankruptcy” Case?–Part 1

You can usually keep your tax refund(s), although it may take some maneuvering.

 

If you are filing your tax return(s) for the 2013 tax year by the October 15 extended deadline, it’s a little less likely that you have a tax refund coming back to you. People who expect a tax refund tend to file as soon as they can to get that refund into their hands, well before the regular April 15 deadline, and so don’t usually ask for an extension.

But there can be all kinds of reasons you are preparing and sending in your tax returns now even though you’re owed a refund. You may have thought you owed for this year but have found out that you get a refund instead. You may owe to the IRS but have a refund coming from the state. Or you may owe for an earlier year or two but are getting a refund for the current. Or you may have just procrastinated.

For whatever reason, you now want to know what happens to that refund if you do file a Chapter 7 bankruptcy case.

Why This Is Even an Issue

In theory, Chapter 7 “discharges” (forever writes off) most debts in return for the debtor’s surrender of all assets that are not “exempt”—that aren’t protected—so that those assets can be sold by the bankruptcy trustee and the proceeds distributed to the creditors. But in reality, most Chapter 7 cases result in the discharge of debts with NO loss of assets. That’s simply because most people who file bankruptcy only own assets that are exempt.

A pending tax refund is an asset of the debtor even if he or she has not yet received it. Why? Because as soon as the tax year at issue is over, he or she becomes fully entitled to that refund. For legal purposes it belongs to the debtor even if it is not yet in his or her possession.

You Can Protect a Tax Refund if It Is Exempt

Like any other asset in bankruptcy, you may be able to claim exemptions to keep all or part of your pending tax refund.

The applicable exemptions differ from state to state, even though bankruptcy is federal law. That’s because bankruptcy explicitly gives each state the right either 1) to require its residents to use its own set of exemptions or else 2) to give people the option of using those state exemptions or a set of federal ones.

In many states (and with the federal set of exemptions in the Bankruptcy Code) there is no exemption specifically for tax refunds. Instead you have to use other open-ended exemptions, such as “wildcard” ones that can be used for anything. Those are available only if you do not have other assets for which you needed to use those exemptions.

If your entire refund is covered by an applicable exemption, you will get to keep the refund to use for whatever you want as soon as your Chapter 7 trustee agrees that the refund is indeed exempt. That usually takes place at the so-called “meeting of creditors” about a month after your case is filed.

If your refund is not fully covered by the exemption, leaving a portion of it not exempt, you may well have to pay that remaining portion to the trustee, to be distributed to your creditors. However if that amount is relatively small, the trustee may let you keep it anyway. See our next blog post about that.

Tax Refunds Including the Earned Income Tax Credit or Child Tax Credits

There is an extra twist with tax refunds that consist, in part, of these tax credits.

The earned income tax credit is a benefit for working people—those with “earned income”—who have low to moderate income, particularly benefitting those who have children or other dependents. It can result in you getting a tax refund larger than the amount of all the taxes withheld from your paychecks that year. Whether you qualify for the credit, and its amount, depends on the amount of your income and the number of your dependents.

Some states have a special exemption for the earned income tax credit, which specially protects that portion of a tax refund. In certain states the amount is unlimited, protecting the full amount of that tax credit no matter how large. In that situation, with the earned income tax credit portion of the refund covered, only any remaining portion has to be protected through another exemption to prevent it from being claimed by the bankruptcy trustee.

Be careful to distinguish the earned income tax credit from state and federal child tax credits. An exemption for the earned income tax credit does not generally cover the portion of a tax refund related to a child tax credit. Instead the child tax credit portion must usually be either exempted in the same way as the rest of the tax refund—through a “wildcard” or other applicable exemption.

Next…

We’ve covered here why tax refunds can be a concern in a Chapter 7 case, and the role of exemptions in protecting it. In our next blog post in a couple days we’ll talk about keeping your tax refund if it is too small for the trustee to bother with, keeping the refund by filing your Chapter 7 case after receiving and appropriately spending the refund, and related issues.

 

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