You can’t keep your refund if you owe for another tax year. But if you discharge (write off) that tax debt, you can keep future refunds.
In our last two blog post we’ve described three different ways to hang onto your income tax refund in a Chapter 7 bankruptcy: by “exempting” it, by the trustee waiving collection of it, and by first receiving and appropriately spending it before filing bankruptcy.
But these all assume that you have a legal right to get the refund in the first place.
The Refund As Your Asset
A pending tax refund for bankruptcy purposes is one owed to you, and therefore is an asset that needs to be protected. And it usually can be protected. But first it’s important to understand that a pending refund can be an asset in ways more broadly than you might think.
The situation in which a tax refund likely most feels like an asset that you have a right to is when you have filed a tax return and are waiting for the refund. It feels real because you have an amount of the refund you are expecting and it’s just a matter of a few weeks that you expect to get it.
But a pending tax refund includes one you are expecting or hoping for but have no idea of the amount. The most common example is after December 31 of the tax year at issue has passed (at which point your refund has fully accumulated) but before your tax returns are prepared. The tax refund is your asset for bankruptcy purposes regardless that you haven’t yet prepared and filed your tax return and don’t know its amount.
At that point you may even inaccurately think you owe taxes and have no refund coming. But if you are wrong and are actually owed a refund then that refund is part of your Chapter 7 case regardless that you didn’t think you had one coming.
Even during the end of the tax year at issue, as odd as it may sound, if a tax refund would be paid to you after filing your tax return during the following year, a PORTION of that current-year refund—the portion that has accrued up to the date your Chapter 7 is filed—may be treated as an asset. That is why some bankruptcy trustees ask about this, especially late into the tax year when most of the refund has accrued, and especially with debtors who are expecting a relatively large refund, thus making the trustee’s effort more worthwhile.
The point here is that tax refunds can usually be protected, but it’s important to know all that needs to be protected.
Your Legal Right to Your Refund vs. the IRS’s/State’s Setoff Right
If at the time you file a bankruptcy case you owe a taxing authority—the IRS or the state—income taxes for a prior year, and you are also owed a refund for another year by the same tax authority, that taxing authority can take the refund as a payment on the tax owed. If the refund is larger than the tax owed, you have a right to the difference. If the tax owed is larger than the refund, you receive nothing.
This is called a setoff right. It only applies if the refund and tax owed are both with the same taxing authority, and generally are both for tax years that ended before the bankruptcy filing.
So, to the extent that the refund is larger than the tax owed, you only have a right to and only need to protect that part of the refund that will remain after paying off the tax through the setoff.
And if the tax owed is larger than the refund, you will not have a right to any of the refund and so have no refund to protect in your Chapter 7 case.
The IRS/State Don’t Violate the “Automatic Stay” When Taking Your Refund through Setoff
Setoff rights exist not just with taxing authorities but with other creditors as well. In general, if you file bankruptcy and you owe somebody a debt, but they owe you money as well, they can reduce the amount of their debt to you by the amount of your debt to them. For example, if you owe someone $1,000 and he or she owes you $1,500, you can’t discharge that $1,000 in bankruptcy and still require your debtor to pay the full $1,500. As in the tax situation, this person would be able to set off your $1,000 debt against the $1,500, leaving him or her owing you only the difference, $500.
But usually setoffs are not allowed once a bankruptcy is filed without the approval of the bankruptcy court. That’s because there are certain timing and other conditions in which setoffs are allowed or not allowed in bankruptcy. A creditor exercising a setoff is treated as if the creditor was forcing a payment or partial payment of the debt, which is what a setoff essentially is. So like most kinds of forced payment of a debt—a payroll garnishment, for instance—a setoff is usually not allowed because of the “automatic stay,” which stops most forms of debt collection the moment a bankruptcy is filed. This allows the bankruptcy court to help oversee the appropriateness of setoffs in each situation.
But there is a big exception for taxing authorities. Setoffs of tax refunds for taxes owed to the same authority, in which both refund and tax owed are for tax years before the bankruptcy filing, are allowed as an exception to the “automatic stay.” That is, the IRS/state can set off your refund against any tax owed to that same tax authority WITHOUT first asking for the court’s permission.
IRS/State Loses Future Setoff Rights on Taxes Discharged in Bankruptcy
Income taxes can be discharged if they meet certain conditions. See an earlier blog post in this series about these conditions.
If you file a Chapter 7 case resulting in a tax debt being discharged, the IRS/state cannot set off any of your future year tax refunds to credit against that discharged tax. The taxing authorities’ setoff rights into the future end on any discharged tax.
Any subsequent tax refunds are yours, free from the reach of the taxing authority, and from the Chapter 7 trustee as well.