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Posted by: Rob Cohen
Last updated March 28, 2017.
It comes up every tax season. You’re looking forward to receiving a big tax refund check, and you’re also working hard to get your bankruptcy case filed. So, what happens to your tax refund in a bankruptcy case?
We’ve said it time and again on the forum: Tax refunds are the number one asset that trustees routinely take from debtors. Exemption laws in most states only go so far to protect cold, hard cash, and anything over and above your state’s designated exemption is fair game for the trustee.
Trustees love to go after tax refunds because, unlike real estate and other assets, there isn’t the overhead and effort associated with listing the property for sale. With cash, they can get a check.
- Your Tax Refund is Part of the Bankruptcy Estate
- Want to Keep Your Refund? Spend it.
- When the Tax Refund Hits While You’re in Bankruptcy…
- How can you avoid this problem altogether? Don’t receive a tax refund
- Other Bankruptcy Tax Refund Issues
Your Tax Refund is Part of the Bankruptcy Estate
On the day the bankruptcy is filed, any assets that you own become part of the “bankruptcy estate.” Your tax refund is one of those assets. A trustee is appointed to represent your creditors, collecting assets and liquidating those assets to pay your creditors. In many Chapter 7 cases, there simply are not enough assets or cash to make it worthwhile for the trustee to take those to pay the creditors.
Unfortunately, if you are owed a large tax refund, that may be an easy target for the trustee. With a little planning, we can help you keep most, if not all, of your tax refund.
Exception to the Rule: Earned Income Credit
There are some exceptions to the general rule that the trustee is entitled to any refund not received and spent prior to filing. In Colorado, for example, any refund attributed to Earned Income Credit and Additional Child Tax Credit is yours to keep. The rest is subject to turnover.
Want to Keep Your Refund? Spend it.
The best way to avoid losing your tax refund is to file your tax return, receive the refund and spend it prior to filing your bankruptcy. Your bankruptcy attorney should instruct you to keep a record of how your refund is spent.
Your refund can be used for a variety of expenses, including most of your ordinary household expenses, like:
- Mortgage payments
- HOA dues
- Educational expenses
- Medical and dental expenses
- Home maintenance and repairs
- Car payment
- Car repairs and maintenance
You want to have minimal — if any — tax refund money in your bank account on the day that you file your bankruptcy. You may also be eligible to save a portion of your refund using a retirement account. Ask your attorney for more information.
If you are able to follow these steps, you will not be required to turn over your tax refund.
Caution! If you spend your tax refund on luxury goods, use it to repay a friend or family member, or pay off a credit card or other unsecured debt, you may trigger an objection from the trustee, and be required to turn over your tax refund, even if you HAVE spent the money.
If you have NOT received your tax refund on the date of filing, the trustee will be entitled to the tax refund when you receive it.
When the Tax Refund Hits While You’re in Bankruptcy…
Ideally, you’ll have very little tax refund left over by the time you’ve filed bankruptcy, and will avoid the plight of Mr. Ellman, below.
In Re Ellman involved a public school teacher in Baltimore, Maryland, who filed for chapter 7 bankruptcy and thereafter received a $15,827 tax refund. The case trustee filed a motion for turnover and the U.S. trustee appeared at the hearing in support of the trustee’s motion. The debtor argued that he relied on his tax refund for living expenses for the upcoming year and that his refund should be excluded from the bankruptcy estate as future wages.
Citing a long line of cases that include tax refunds as part of the bankruptcy estate, the court found the debtor’s argument unpersuasive and ordered that he turn over the funds minus approximately $10,000 he had available in unused exemptions. In total, Mr. Ellman was ordered to turn over $4,615 of his tax refund. To support its ruling, the court in In Re Ellman recited an uncontroversial rule of bankruptcy law that applies to tax refunds:
Income tax refunds are property of a debtor’s bankruptcy estate to the extent they are derived from withholdings from the pre-petition earnings of the debtor.
To put the court’s words in plain English, tax refunds received for wages earned prior to filing bankruptcy are considered property of the bankruptcy estate and are subject to liquidation if no exemptions are available.
Part of the job of any good bankruptcy attorney is to sit down with clients, discuss their assets and come up with a plan for maximizing the exemption laws to their client’s benefit. If you’re considering filing for bankruptcy and are unsure of how a large tax refund will be treated, consult with an experienced bankruptcy lawyer before making any further decisions.
How can you avoid this problem altogether? Don’t receive a tax refund
If you had a large tax refund last year, the first thing we will ask you to do is to look at your W-4 and adjust your exemptions. You only want to have the necessary taxes withheld from your paycheck, nothing more.
When you are filing for bankruptcy you DO NOT want to receive a tax refund. At a minimum, keep the tax refund small.
Instead of receiving a tax refund and giving it to the trustee, wouldn’t you like to have a little more money coming to you in each paycheck throughout the year? I thought so! You can use the IRS’ withholding calculator to determine how many deductions you should be claiming.
Other Bankruptcy Tax Refund Issues
If we file your case later in a year (between August and December), it is likely that the trustee will ask for a copy of that year’s tax return. I know this sounds strange since it’s September and you have not filed a tax return for the current year. The trustee may request a copy of the tax return for the current year as soon as you file it. He will then review the tax return to see if you are going to be receiving any refunds. If you are, he will ask for a pro-rata portion of the refund.
Since your initial appointment with the attorney may be several months before you actually file your case, we want you to plan for your bankruptcy by adjusting your payroll deductions to avoid having the trustee take your refund.
Bottom line: You should plan to have a minimal refund if possible; or wait for the refund to be received prior to filing for bankruptcy. No refund means you get to keep your money in each paycheck and avoid turning over a big refund to the trustee.
Rob Cohen, the Managing Partner of Cohen & Cohen P.C., is a bankruptcy attorney that practices in Colorado and Wyoming. He serves as a Chapter 7 Bankruptcy Panel Trustee, and has to date administered over 8,000 Chapter 7 bankruptcy estates. Rob is a Certified Consumer Bankruptcy Specialist, and was nominated for Denver Business Journal’s 40 under 40 in both 2014 and 2016.