Income Tax Refunds in a Chapter 13 Case

Chapter 13 gives you more flexibility about what you can do with your current income tax refund. But unlike Chapter 7 which doesn’t care about your future years’ refunds, Chapter 13 does.

As I said in my last blog, if you file a Chapter 7 bankruptcy after the beginning of the year, at a time when you’re still due a tax refund on the year that just passed, your trustee is going to be very interested in that refund. It’s your money that the government is simply holding for you until you claim it.  That’s true even if you haven’t yet filed your tax return, or don’t even know the amount of the refund. Whatever the amount, it’s still your money—you just haven’t yet claimed it or calculated the amount by filing the tax return. So unless that refund fits within an exemption, or is small enough to not be worth the trustee’s bother, the trustee is going to get that refund.

Chapter 13 comes with some good news and some bad news on tax refunds.

The good news comes from Chapter 13’s flexibility when it comes to assets that are not exempt. In a Chapter 7 case, non-exempt assets simply go to the trustee to be distributed to creditors according to a very rigid formula.  In Chapter 13, in contrast, you may be able to use that refund in two very beneficial ways.

First, you may be able to get permission to use the refund, or a part of it, for a necessary, one-time expense. A standard example is a critical vehicle repair, needed to be able to commute to work. The expense usually needs to be an extraordinary one, over and beyond what would be included in your standard monthly budget.

Second, to the extent that you are required to pay the refund over to the trustee, in a Chapter 13 case you usually have somewhat greater control over where that money will go. Your attorney might be able to explicitly earmark, through a specific provision in your Chapter 13 plan, where the trustee pay some or all of that refund. More likely, in certain cases, with careful wording of your plan, your attorney may be able to nudge that money in a particular direction that may be more favorable to you. For example, a vehicle that you need to keep could be paid off faster than otherwise, thus taking away from that creditor any grounds for objecting.    

Now the not-so-good news. One positive aspect of Chapter 7 is that it’s fixated on what assets you have a right to as of the moment your case is filed.  But Chapter 13 is by its very nature also interested in your future income during the three to five years that you are expecting to be in the case. And for most purposes future tax refunds are considered future income. So your Chapter 13 plan has to account for the tax refunds that you would be receiving during the years that you are in the case. In most cases that means that you must turn over your tax refunds to the trustee to be paid out according to the terms of your plan.

The truth is that this is not necessarily bad:

• If you usually get large tax refunds, your withholdings should likely be adjusted so that you can put that money to use during the year for your regular living expenses. This is especially helpful if your budget is tight. Doing so would reduce the size of the refunds going to the trustee, minimizing this problem.
• In some situations, a year or two into a case you may be able to get permission to use that year’s tax refund for a new special expense, such as ,again, for a new vehicle repair.
•  Even if the refunds do just go to the trustee during the course of your case, sometimes that extra money flowing into your Chapter 13 plan finishes your case faster, in other cases it may result in important creditors being paid more quickly, and finally sometimes the refunds may enable you to pay off the plan within the mandatory maximum deadline.