Over the past few weeks we discussed what may be taxable, how to eliminate taxes, and what happens to tax refunds in a bankruptcy. This post is going to address instances where a couple files a joint tax return, but only one spouse files for bankruptcy relief.
First, let me remind you that it is possible for one spouse to file bankruptcy while the other does not. I will go into detail on how that works in a later post. When a couple files a joint tax return, they will either receive a refund or owe taxes (yes, they could occasionally break even). What happens with that tax liability or tax refund is a little different when only one spouse seeks bankruptcy relief.
Tax Refunds:
As I discussed last week, a tax refund can be protected in a Chapter 7 if there is an exemption available. If there is no exemption to protect that refund, would a trustee get the full refund? Courts are split on this nationwide and I have seen bankruptcy trustees take different approaches.
The simplest approach is to split the refund 50-50, where the spouse who does not file (non-filing spouse) can keep his or her half of the refund and the bankruptcy trustee takes the other half. A more complicated view is to look at the income of the two spouses, and the non-filing spouse can keep his or her refund in proportion to his or her share of the household income. The IRS has an even more complicated approach. This requires a close examination of each spouse’s income and withholdings to determine each spouse’s share of the tax refund. Depending on the couple and the tax return, this may require the assistance of an accountant.
When one spouse files a Chapter 13 bankruptcy, the entire refund is safe if the Chapter 13 repayment plan pays all creditors in full. However, if the plan is paying unsecured creditors at a percentage, the entire tax refund must be turned over to the bankruptcy trustee, and the non-filing spouse is not entitled to keep any of it. The reason is that in a Chapter 13 plan, both spouses pledge all their disposable income to fund a Chapter 13 plan. If both spouses had proper withholdings during the tax year and therefore not receive a refund (but also not owe) there would be more disposable income for creditors.
Taxes Owed:
If both spouses owe taxes they should review their financial situation with an experienced attorney before determining whether it makes sense for only one spouse to file for bankruptcy relief. When the taxes owed can be dischargeable in a bankruptcy and only one spouse files for bankruptcy relief, the obligation will only be eliminated with regard to that one spouse. The non-filing spouse will still be on the hook for the debt so part of the household budget will need to go towards paying that debt anyway.
When a tax obligation is not dischargeable and one spouse files for Chapter 13 bankruptcy relief, the rules change once again. While bankruptcy stops all collections, and will generally protect co-debtors (more on that in a later post) as well, taxing authorities can still collect from a non-filing spouse. Taxes are not treated as consumer debt so the concept of a co-debtor stay does not apply. However, once a Chapter 13 repayment plan is confirmed (approved by the court) the taxing authority may stop collecting from the non-filing spouse since the repayment plan will be paying the taxes in full.
Taxes are not the most exciting subject, but they play a big part of most bankruptcy cases. Whether you owe taxes or are due a refund, it is always best to speak with a knowledgeable and experienced attorney who can protect your interests.
Zimmelman Law PLLC
Latest posts by Zimmelman Law PLLC (see all)
- New York State Foreclosures To Quickly Proceed After NY Court Of Appeals Ruling - February 17, 2023
