Is Early in the Year a Good Time to File Bankruptcy?

The beginning of the year can be either a good time or a bad time to file bankruptcy. The distinction boils down to tax-related issues, and filing your personal bankruptcy during this time can either be a boon or a bust for your finances. The general rule is: if you owe taxes, file early. If you expect a refund, wait.

Why early in the year is a good time to file bankruptcy

Many Chapter 13 debtors wait until after the first of the year to ensure that the prior year's tax debt is included in the bankruptcy. While recent tax debts are not dischargeable in either a Chapter 7 or Chapter 13 bankruptcy, paying a tax debt through a Chapter 13 plan can stop accruing interest and spread equal payments over three to five years. These payments are made under the supervision of the bankruptcy court and without fear of garnishment or seizure by the IRS.

Why early in the year is a bad time to file bankruptcy

Filing bankruptcy at the beginning of the year can put an anticipated tax refund at risk. When an individual files bankruptcy, all of her assets become property of her bankruptcy estate. This includes any income tax refund that is not yet received. The debtor is able to use legal exemptions to protect this money, but a Chapter 7 trustee can demand turnover of the non-exempt portion of an expected refund. In a Chapter 13 case, the debtor may have to pay an increased plan payment to account for a non-exempt tax refund.

The solution to managing an at-risk tax refund is to avoid filing bankruptcy until after the tax refund is received and spent. Your bankruptcy attorney can discuss strategies for spending a tax refund without fear of reprisal from a bankruptcy trustee.

Can I Keep My Future Tax Refunds After I File Chapter 13?

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 re-emphasized the need for a Chapter 13 debtor to commit all of his or her disposable income to repaying creditors during bankruptcy.  Since that time, Chapter 13 bankruptcy trustees across the country have argued that tax refunds constitute disposable income – income not needed by the debtor to pay reasonable and necessary expenses, such as food, transportation and shelter. Courts have unanimously agreed with the trustees: tax refund money is surplus, and the Chapter 13 debtor must turn over these refunds to the bankruptcy estate.

There are a few ways to combat this loss during a Chapter 13 bankruptcy.  The most obvious way is to not create a tax refund in the first place. This means careful vigilance of your tax situation. Instead of Uncle Sam holding onto your money throughout the year, make sure that you only give the tax man what is owed – and no more.

Another way to avoid an income tax loss is to include language in the bankruptcy plan that excludes income tax refunds. This exclusion must be supported by evidence of the need to pay a reasonable and necessary expense. For instance, you may propose to pay annual property taxes with income tax refunds. These types of proposals have a low success rate and will almost always draw an objection from the trustee or a creditor.  Furthermore, the bankruptcy court may be reluctant to allow this proposal due to the unpredictable nature of using a tax refund as income (the refund may be what you expect, it may be more, it may be less, or it may not come at all).

Finally, many Chapter 13 debtors attempt to modify their plans to excuse a particular refund, or part of a refund. Some courts and trustees will allow a debtor to keep money from an income tax refund when the debtor shows that the money is needed to pay reasonable and necessary expenses.  For instance, if the debtor suffers an unexpected expense, such as an unexpected medical bill, funeral expenses, or a car repair, the debtor may be able to keep tax money to cover the expense.  The bankruptcy court will not allow the debtor to keep tax money to pay for food, utilities, a car payment, or other expenses that should be paid by the debtor’s regular income.

Income tax refunds (and underpayment of taxes) during Chapter 13 bankruptcy always cause headaches, so the best advice is to pay attention to your income. A regular visit to a seasoned CPA will avoid tax issues and keep more money in your pocket.