Protecting tax refunds in a Chapter 7 bankruptcy

Many bankruptcy filers are concerned with the treatment of tax debt and tax refunds. How tax issues are handled in bankruptcy depends on when a person files for bankruptcy and the "Chapter" under which the proceeding was filed.

In a Chapter 7 bankruptcy, some of the bankruptcy filer's non-exempt assets are given to a trustee, who "liquidates" the bankruptcy estate to creditors to pay off debt. Once distributed according to the bankruptcy plan, the filer receives a discharge on any remaining eligible debt. A bankruptcy filer's "estate" includes tangible assets like a home, car, bank accounts and physically owned property, and it also includes such intangible assets as debts owed to the filer. Thus a tax refund, even if not yet paid, can be included in the estate and distributed — unless it is exempt.

It is important to note that many assets are exempt from inclusion in the bankruptcy estate, so don't delay filing just because you are worried about losing your possessions. Many valuable assets, like a residence or a vehicle, can be kept after filing bankruptcy.

What part of the bankruptcy estate is exempt depends upon state and federal exemption laws. Because a debtor can only receive a certain amount of exemptions, exempting a tax refund might mean other property such as bank accounts, valuable collections, secondary autos or expensive jewelry might instead be used to pay off creditors.

Treatment of tax returns

It is possible to receive a tax refund prior to filing bankruptcy, spend the money, and not have it included as part of the bankruptcy estate. However, this must be done with the advice of a bankruptcy attorney, as not all purchases will be non-exempt. Bankruptcy filers who have already received a refund may choose to spend it on rent, food or living expenses, for example. Tax returns for the current fiscal year and a few years prior must be provided as part of the bankruptcy filing; only then can a determination be made as to how any remaining or pending refund amounts will be treated.

Once a person knows he or she will file for bankruptcy, there are steps to take to avoid giving a tax refund to creditors. One way is to reduce withholdings. This will give the debtor more money per paycheck and make any tax refund negligible. If a tax refund is small enough, a trustee may conclude that obtaining it is not worth the cost of collection.

A judge may allow a debtor to keep a tax refund if needed to pay unexpected expenses. Medical bills, car repairs and funeral expenses are examples of items a bankruptcy court judge may allow a debtor to pay off using a tax refund. Remember: tax returns on income gained after filing bankruptcy are not included as part of the bankruptcy plan.

An experienced bankruptcy attorney can help

Tax matters in bankruptcy are highly dependent on individual circumstances and applicable laws. If you are considering bankruptcy, speak to an experienced bankruptcy law attorney to discuss your legal options.