Income Tax Refunds in Chapter 7 Bankruptcy

Can you keep your tax refund if you file a Chapter 7 case? It’s mostly a matter of timing.

Here are the bullet points:

Everything you own at the time your Chapter 7 bankruptcy case is filed becomes your “bankruptcy estate.” Usually, most or all of that “estate” stays in your possession and you get to keep because it’s “exempt,” or protected.

That “estate” includes not only your tangible, physical possessions, but also intangible ones—assets you own that you can’t physically touch—such as money owed and not yet paid to you.

Depending on the timing, a tax refund can be an intangible asset that becomes part of your bankruptcy estate. Then whether you can keep it or not depends on whether it is exempt.

Because an income tax refund usually consists of the overpayment of payroll withholdings, the full amount of that refund has accrued by the time of your last payroll withholding of that tax year. So even though nobody knows the amount of your refund until your tax return is prepared a few weeks or months later, for bankruptcy purposes it is all yours as of the very beginning of the next year.

So if you file a Chapter 7 case after the beginning of the following year and before you have received your tax refund, it is part of your bankruptcy estate and the trustee can keep it if it is not exempt, or can keep as much of it as it not exempt. That’s also true if you have received the refund and not done anything with it.

You can avoid this by filing your tax return and receiving and appropriately spending the refund before your Chapter 7 case is filed. DO NOT do this without very specific advice from your attorney. The bankruptcy system is very interested in what money you receive and precisely how you spend it before filing bankruptcy, and you can very easily get into trouble if this is not all done very carefully.

If the bankruptcy is filed so that the refund is an asset of the bankruptcy estate, whether or not it is exempt depends on how large it is and how much of an exemption is allowed in your state. In some cases, using all or part of an exemption for the tax refund may reduce the availability of the exemption for other assets.

Some states have specific exemptions applicable to certain parts of the tax refund, or laws that exclude them from the bankruptcy estate altogether, particularly regarding the Child Tax Credit or the Earned Income Tax Credit. These likely do not exist in a majority of the states, but it’s worth checking.

Even if the refund, or a portion of it, is not exempt, the Chapter 7 trustee may still NOT claim it if he or she determines the amount is not enough to open an “asset case.” That is, the amount of refund to be collected is so small that the benefit of distributing it to the creditors is outweighed by the administrative cost involved. You might hear a phrase similar to the amount being “insufficient for a meaningful distribution to the creditors.” This threshold amount can vary from one court to another, indeed from one trustee to another, so be sure to discuss this with your attorney. But note that if the trustee is collecting any other assets, then most likely he or she will want every dollar of tax refunds that are not exempt.

There is a risk that you will not be able to claim an exemption if you don’t list the tax refund to which the exemption applies. So be sure to always list any tax refund to which you may be entitled.

Although I’m focusing on this issue now because we are in tax season, the same principles apply year-round. Frankly, it can be a little harder to wrap your brain around this as applied to, say, filing a bankruptcy in the middle of the year. As of July 1, you’ve had a half-year of tax withholdings deducted from your paychecks and forwarded by your employer to the taxing authorities. So, assuming the same amounts were withheld throughout the year, if you end up getting a substantial refund the following spring, for bankruptcy purposes about half of that had accrued by mid-year. So a bankruptcy filed on July 1, needs to take that into account. Some Chapter 7 trustees don’t push this issue much until the last quarter of the year, when that much more of the refunds have accrued. But regardless, tell your attorney about income tax refunds anticipated the following year, particularly if you have a history of relatively large tax refunds.