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Tax season is here again. Understandably, people filing or considering filing Chapter 7 are concerned about losing their tax refunds. The good news is that if done properly, the bankruptcy filing will most likely not cause the loss of a tax refund. Most debtors lose their tax refunds because they fail to properly disclose and exempt the tax refunds, which is common when attempting to file without an attorney or when hiring an inexperienced or careless bankruptcy attorney.
The Bankruptcy Estate
Upon filing a bankruptcy, all of the debtor's assets become property of the bankruptcy estate. The bankruptcy estate is administered by a person called a trustee. It is the trustee's job to liquidate assets for the benefit of the debtor's creditors. The Bankruptcy Code defines assets very broadly. Assets include things a debtor owns at the time of filing, will own in the future, or could own upon some event occurring. What is considered an asset is not always obvious to a layman, which is why it is so important to hire an experienced and thorough bankruptcy attorney.
What Tax Refunds Are Part of the Bankruptcy Estate
Tax refunds, or the right to receive tax refunds, are an asset in almost every Chapter 7 bankruptcy. Most debtors understand that tax refunds that they are holding at the time they file bankruptcy are an asset. Most debtors also understand that tax refunds that they will receive during the same calendar year they file bankruptcy are an asset. What most debtors do not realize is that a portion of the tax refunds associated with the calendar year the bankruptcy petition is filed are also an asset. In other words, if you file bankruptcy in 2014, a portion of the 2014 tax refunds which will be received in calendar year 2015 are part of the bankruptcy estate.
A debtor's marital status and how they file tax returns can also have an impact on how much of the refunds are part of the bankruptcy estate. Typically, if a married individual files bankruptcy without their spouse and the tax returns resulting in refunds were filed jointly, only 50% of the refunds are considered assets of the bankruptcy estate.
Here's one example of how the tax refund issue can play out:
An unmarried debtor files their 2013 and 2014 city, state and federal tax returns on March 31, 2015. Debtor files a Chapter 7 petition on April 1, 2015. The following are assets of the bankruptcy estate:
- 100% of the 2013 city, state and federal tax refunds
- 100% of the 2014 city, state and federal tax refunds
- Approximately 25% of the 2015 city, state and federal tax refunds**
**If the bankruptcy is filed April 1st, 90 days of calendar year 2015 have passed. As such, the prorated portion of the 2015 tax refund can be calculated by dividing 90 days by 365 days.
Obviously, at the time the bankruptcy petition is filed a debtor can't file their tax returns for a calendar year that has not yet completed. It is also impossible to predict to the dollar what the refunds will be from tax returns that have not been prepared. Nonetheless, a debtor must do their best in disclosing an anticipated prorated estimate for tax refund related to the incomplete calendar year. This estimate can be done by looking at previous years' tax returns.
Protecting Tax Refunds With Exemptions
The Bankruptcy Code was designed so that individuals could get a "fresh start." Part of that fresh start is making sure that an individual doesn't lose everything to trustee liquidation. As such, the Bankruptcy Code allows for certain exemptions.
Tax refunds, like cash in a bank account, are protected or exempted with an exemption referred to as "wildcard." Currently, the wildcard exemption has a limit of $12,725.00 per debtor (amount is periodically adjusted). However, the ability to exempt a tax refund may be limited by the ownership of other assets. If a debtor has other assets that require exemption and wild card is the only way to protect them, there may be a liquidation issue.
By consulting with an experienced bankruptcy attorney, liquidation issues can be discovered, discussed and planned for. In regard to tax refunds, a liquidation issue may be avoided by coordinating the timing of your bankruptcy filing and the anticipated receipt of your tax refunds. An attorney can help determine if an adjustment of your tax withholding or spending refunds on necessary expenses can help. Before spending down your tax refund to avoid liquidation, a conversation should always be had with an attorney so that you know the expenses would be considered necessary by the bankruptcy court.
The Bottom Line
Filing Chapter 7 doesn't mean you will automatically lose your tax refunds. The key is full disclosure, proper use of exemptions, and intelligently timing the filing of the bankruptcy petition. Hiring an experienced and thorough bankruptcy attorney will ensure that you can keep most, if not all, of your tax refunds.