Protecting Your Income Tax Refund

The traditional wisdom regarding bankruptcy and tax refunds is: get it and get rid of it before filing bankruptcy. The bankruptcy trustee can’t take what you don’t have, right? 

In the law there are rarely absolutes. In some cases the trustee can demand money that you no longer have in your possession. A common example of this is a preference payment to an insider creditor (e.g. repaying a loan to your mother from your tax refund). The trustee can sue you or your creditor for the turnover of the money. 

The simplest way to avoid any potential loss of your income tax refund is to discuss the situation with your bankruptcy attorney. In many cases your attorney can exempt all or a portion of your tax refund, so you can keep the cash money after you file bankruptcy. First, you are required to identify the property in your bankruptcy schedules, and then apply the applicable exemption law to protect it. Failure to list or exempt this asset may render the entire amount unprotected and lost to the bankruptcy trustee. 

If your exemptions will not protect all of your income tax refund, you should consider spending the difference to benefit your family. The best guidance is to spend the money on goods or services that are reasonable and necessary. While your attorney can help you decide on specific purchases, the following categories are generally safe: 

1.  Household expenses such as utility bills, mortgage or rent payments, car payment, auto insurance, and needed auto repairs/tires

2.  Personal expenses such as food and clothing, dental work, and medicine

3.  Priority debts like child support arrears and tax debts 

Luxury good purchases like electronics, vacations, and jewelry should be avoided. Likewise gifts to family members or friends, spending sprees, and gambling should all be avoided. Any payment from your tax refund that you plan to make to a creditor should be discussed with your attorney. 

Your income tax refund is your money! You can ensure that this money benefits your family by discussing your situation with your bankruptcy attorney.

Will I Lose My Tax Refund by Filing Chapter 13 Bankruptcy?

A Chapter 13 bankruptcy is a repayment plan that lasts three to five years.  During that time the debtor is required to devote all disposable income to the repayment of debt.  Most bankruptcy trustees and courts consider tax refunds part of the debtor’s disposable income that is over-withheld and should be paid into the Chapter 13 plan.  However, instead of reducing the amount payable under the debtor’s plan, tax refund money is paid to unsecured creditors that would otherwise not be paid.  If the debtor is paying a 100% repayment plan, the trustee will not request turnover of any tax refunds.

Some courts have approved a provision in the Chapter 13 plan that requires the Internal Revenue Service to forward any tax refund to the trustee’s office.  However, at least one bankruptcy court has found this practice to be unlawful.  In United States v. Carroll, No. 2:09-cv-13505 (E.D.Mich. Jan. 20, 2010), the bankruptcy court concluded that the IRS was not a party to the debtor’s chapter 13 case and did not have an opportunity to object to the plan.  Additionally, as a part of the United States government the IRS possesses sovereign immunity that it did not waive. 

Keeping your money and avoiding an income tax turnover may be as simple as adjusting your paycheck withholding.  By speaking to a tax professional you may be able to predict your tax liability and put more money in your pocket each payday.  However, be careful to avoid a situation where you do not withhold enough taxes and end up with a large tax bill at the end of the year. 

If your tax refund is largely due to an Earned Income Tax Credit (EITC), the IRS allows tax payers to request an advance payment of the EITC.  Information regarding this advance payment program can be found on the IRS website.   If you qualify, your employer will add additional money to your take-home pay each paycheck. 

If you want to avoiding surprises during your Chapter 13 bankruptcy, seek out and hire an experienced bankruptcy attorney.  An experienced bankruptcy attorney can discuss your financial situation with you and help you keep your hard-earned money for your family.

Are Future Tax Refunds Required to Be Turned Over in a Chapter 13 Case in the Western District of Kentucky?

A debtor filed a Chapter 13 bankruptcy in the Western District of Kentucky.  A year later the debtor filed her tax returns and received a combined Federal and Kentucky tax refund in the amount of $1,563.00. The debtor spent the money to catch up on household bills.  Later, the Trustee filed a Motion to Dismiss her case because she didn’t turn over her tax refunds.  What happened? Under our local Rule 13, all Chapter 13 debtors who are paying their unsecured creditors less than 100%, must turn over copies of their tax returns, tax refunds and an updated budget.  The theory behind this local rule is that when a debtor files a Chapter 13 case, she is agreeing to repay her debts to creditors to the extent that there is income available to pay them.  The debtor is in control of the income and is responsible to pay the defined plan payment to the trustee each month.  Once a bankruptcy is filed, an estate is automatically created and consists of property of the debtor, including all income or earnings earned after the case is filed up to the point in time that the case is discharged, dismissed, or converted.  Since it can be argued that tax refunds are considered future income, the judges in the Western District of Kentucky created a local rule that requires this turnover of refunds to the trustee.  Interestingly, the judges in the Southern District of Kentucky and the Eastern District of Kentucky do not express the same views and do not require this annual turnover of tax refunds probably because they consider a tax refund not to be “income” but to be an overpayment to the IRS for taxes that were withheld from the debtor’s paycheck.