It’s tax season again and that leads us to the inevitable array of questions about what happens to your tax refund if you have, or are thinking about, filing for bankruptcy. Many people rely on their tax refund to cover large expenses. Someone who is in bankruptcy, or is thinking about it, doubtlessly wants to know, “what happens to my refund in bankruptcy?” It’s a common question and the answer is always specific to the individual who is asking the question. There are some rules of thumb that, more often than not, prove to be true.
Can I keep my tax refund if I file for Bankruptcy?
Chapter 7: In a Chapter 7 bankruptcy you may be able to keep some, or all, of your tax refund. This depends on several factors specific to your case. As a general rule, you can keep what you are able to exempt. There are limitations to this so if you receive a substantial refund, it is very likely you will not be able to keep all of it.
The refund is part of the Bankruptcy Estate, meaning it’s potentially subject to administration. Cases filed between December and April should take precautions and claim an appropriate exemption to protect as much of the refund as possible. Your client’s refund is liquid which makes it an easy, and desirable, target for a trustee. Using the most recent tax return to estimate the tax refund is usually safe unless the debtor has had substantially changed circumstances between years.
Filing status also matters; the debtor file taxes jointly but declares bankruptcy as an individual. In these cases, the rule is usually that 50% of the refund is deemed to be the debtor’s and subject to the Bankruptcy Estate. Your tax refund is also subject to pro-rata division based on when in the year you file.
Highlights
- You can keep your tax refund to the extent that you are able to exempt it. Anything that is unexempt you will risk having to turn over to the trustee.
- The taxing authority may set off (seize) against your refund if you owe them money.
- It is important to discuss your exemptions with your bankruptcy attorney.
Chapter 13: In a Chapter 13 you may be able to protect some or all of your refund for one year, but what happens to future returns? That depends on the trustee. In general, if the plan is paying back 100% of filed claims then you can keep your future refunds. If the plan is paying less than 100% what happens to your future refunds depends on the jurisdiction. In many places it is common practice for the Chapter 13 trustee to contact the IRS and have future refunds directed to them for the pendency of the case. In other jurisdictions a fraction of the tax refund is imputed into monthly income. There may be cases where you can petition the court to except the refund from those obligations, but such plans are difficult to confirm.
If you owe the taxing authority from previous years and you file a Chapter 13 Bankruptcy your plan will be designed to repay the taxing authority. Your refund may also be subject to setoff (the balancing of mutual liabilities).
If taxes are owed for years AFTER filing for bankruptcy those obligations are not paid as part of the Bankruptcy plan and must be dealt with as they become due.
The best way to protect a tax refund is either to a) spend it on necessary expenses such as mortgage/rent, food and utilities, recurring secured payments like your vehicle, contribute to your established IRA, or b) adjust your withholdings with your employer so that you do not have a large refund. Not having a refund is actually the best way to protect it.
Highlights
- Your first year’s tax refund is protected to the extent that you can exempt it. What happens after that depends on jurisdiction and the policy of the Standing Trustee for your area.
- A common practice may be to impute 1/12 of your refund (or half your refund in the case of a married person filing for bankruptcy individually) into your monthly income.
- If you are paying a 100% plan your tax refund is generally yours to do with as you please.
- You may be able to keep your future tax refunds by filing modified bankruptcy plans and demonstrating to the court that it is necessary to except your refund from commitment to your plan.
- Your refund may be subject to a set off by the taxing authority.
How do I file my Taxes while I am in Bankruptcy?
During the pendency of your bankruptcy, you must file all ongoing tax returns. Generally, a debtor can file their taxes as normal. However, if they’ve experienced something like surrendering the home or losing it foreclosure, they should engage a tax professional to avoid this appearing as a taxable gain.
After the Bankruptcy is discharged a taxpayer may receive form 1099-C about the debt being cancelled. This isn’t always the case (not every institution will do this), or it may even take several years to receive this form. To avoid negative tax consequences the tax pay should speak with a professional. Debt discharged by under the Bankruptcy Code does not negatively impact one’s income for tax purposes.
Highlights
- During your bankruptcy you MUST continue to file your tax returns timely or obtain an appropriate extension. Failure to do so may result in your case being dismissed or converted.
- Normally, there is nothing special about filing taxes while in bankruptcy. Your specific circumstances may necessitate speaking with a tax professional to be certain.
- After your bankruptcy you may receive cancelation of debt forms (1099-C); if you do you are encouraged to speak with a tax professional.
More information on taxes, tax consequences, and bankruptcy can be found in IRS Publication 908.