A Chapter 7 bankruptcy is an erase-your debts-start-fresh bankruptcy. It is meant to give an individual a chance to begin anew on a financial path without the burden of overwhelming debts dragging him or her down. On the other hand, Chapter 7 bankruptcy is not intended as a way to legally hide from debts the person can afford to pay.
That tension that felt most keenly when dealing with an individual’s income tax refund during Chapter 7 bankruptcy. On the one hand, the debtor is excited about his Chapter 7 “fresh start” and is eager to use his after-bankruptcy tax refund to help him along with his new financial future. On the other hand, his creditors are eyeing his income tax refund as a pre-bankruptcy asset that should be used to repay his debts.
Both creditors and debtors have a claim on the debtor’s anticipated income tax refund. The debtor is entitled to the refund, even though it is not yet received. Consequently, the debtor’s interest in receiving this refund must be included in the debtor’s bankruptcy estate. Because it is property of the estate, the debtor is able to use legal exemptions to protect all or a part of the tax refund. The remaining non-exempt portion must be paid over to the bankruptcy trustee for distribution to creditors. Often debtors are able to exempt enough of an expected income tax refund that it will make the remaining sum de minimis, or so little that it is not worth the trustee’s time or effort to take and distribute the funds.
The debtor must turn over non-exempt tax money even if the refund is not received until after the debtor receives a discharge. The only timing that matters is whether the debtor had a legal interest in the income tax refund at the time he filed the case. When the refund is actually received by the debtor is of no consequence. In many cases a trustee will leave a debtor’s case open until the debtor has both filed and received his income tax refund. This may mean remaining in bankruptcy for many months longer than expected.
The best way to avoid income tax refund problems during bankruptcy is to file the case after the tax refund is both received and spent. Your attorney can direct you on how to spend your tax money and avoid further bankruptcy complications.
Another way to protect non-exempt money from an income tax refund is to apply the non-exempt portion of the expected income tax refund to next year's taxes. The IRS will keep the tax overpayment and use it for taxes owed in the future. The Tenth Circuit case of Weinman v. Graves, 609 F.3d 1153 (10th Cir. 2010) holds that the bankruptcy trustee cannot force the IRS to turnover a tax refund that is held to pay future taxes. The election to apply the refund to a future tax liability is irrevocable under section 6513(d) of the Internal Revenue Code. Consequently, the debtor’s interest in the refund when he files bankruptcy is limited to what is left after the IRS applies the money to next year's tax liability.
If you are considering filing bankruptcy and expect a large income tax refund, speak with an experienced bankruptcy attorney. Your attorney can discuss your options and help you choose the right course of action for the maximum financial benefit using the federal bankruptcy laws.