Tax Refunds and Bankruptcy

Every year as we prepare our taxes we hope that we’re entitled to tax refunds. Most people view tax refunds as a bonus and get excited that they’re receiving money from the government. It’s not that simple. A tax refund is essentially the government paying you back for money you lent them over the past year. Sadly, you do not get interest on that loan.

A tax refund is the difference between the taxes you had withheld for that tax year versus your actual obligation that year. If you had more withheld over the course of a calendar year than your tax obligation, the government was holding onto your money and will return it in the form of a tax refund. When put that way, it really is not a bonus, gift, or free money from the government.

Now suppose you’re considering filing for bankruptcy. Can you keep that refund?

In a Chapter 7 case it depends on whether it is an asset that you can protect. In a previous post I discussed bankruptcy exemptions. A tax refund can be protected if you have an exemption available to do so. The big question is whether you already received that tax refund or whether you are expecting it. If you already received a refund, those funds are sitting in the bank and may be protected depending on what other assets you are protecting and which exemptions are available. If you have not yet received it, it’s a little more complicated. 

So what if you have not yet received your refund? The simplest example is where it’s the beginning of the new year and you either haven’t filed your taxes yet or you’ve filed but are waiting for the refund. Here, a tax refund is viewed as anticipated assets and may be reached by the trustee if you cannot protect it with an exemption. 

There’s another aspect to consider. Let’s say today is August 31, 2021. You filed your 2020 tax returns on time and already received federal and state refunds (and likely spent those funds). As I mentioned earlier, a refund is based on the difference between taxes withheld and taxes owed in a given tax year. A bankruptcy trustee could still reach for a tax refund that you may be entitled to in the year you file for bankruptcy relief, even if the tax year has not concluded. 

Does this mean that if I file a bankruptcy petition on August 31, 2021, a bankruptcy trustee will take that refund? Not necessarily. First, it’s important to note that a trustee can only seek two-thirds of a 2021 refund. This is because a trustee is only entitled to the portion attributed to the tax year up until the petition is filed (Jan 1 – Aug 31), but nothing after that (here, Sept 1 – Dec 31). Second, if you have an available exemption to protect that portion of your refund, it will be safe. One final consideration is that a bankruptcy trustee will (hopefully) exercise good business judgment and only reach for a tax refund if it results in a payment to creditors, while also taking into account the trustee’s fees to administer that asset (notices, motions, reports, postage, and time). 

In Chapter 13 cases it’s much easier. If you are paying all of your creditors in full, you can keep your tax refunds while in a repayment plan. This is because the creditors cannot get more than they are entitled to and that has been allotted by the Chapter 13 plan. However, if you propose a plan that pays unsecured creditors less than 100%, you must surrender your tax refunds to your bankruptcy trustee every year while in a repayment plan.

This is why it’s good to speak with an experienced attorney who can review your assets and determine early on what can be protected. For over ten years, Matthew D. Zimmelman has worked with thousands of debtors to protect assets in bankruptcy. Sometimes a creative strategy must be employed and timing of the filing also comes into play. To learn more about eliminating your debt while protecting assets, give us a call!

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Zimmelman Law PLLC

With over ten years of experience, Matthew D. Zimmelman, Esq. has helped thousands become debt-free and saved countless New Yorkers from losing their homes in foreclosure. Whether you are an individual or a small business, looking to file bankruptcy or looking to eliminate your debt without filing bankruptcy, we are here to help you get a fresh start.
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