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What Happens to my Tax Refund if I File for Bankruptcy?

This is a question asked by many of my St. Louis bankruptcy clients at this time of year. The answer is: sometimes yes, sometimes no.

Let me give a fuller answer by explaining how tax refunds work in a Chapter 7 and a Chapter 13 separately. We’re currently right in the middle of tax season. Everyone is filing the proper forms, and expecting a refund. This is also a time of the year where a lot of people think about filing for bankruptcy because they are getting a refund back from the government. and want to use it to pay their filing fees.

So let’s say you are expecting a large refund. Somewhere in the neighborhood of $5,000.00 or more. If we’re talking about a Chapter 7, what I always suggest to my clients is to do the taxes first, get the refund, spend it, then we’ll file the bankruptcy. Why? We could file the bankruptcy petition before you do your taxes, but the Trustee (the person is appointed by the government to look at your case with a magnifying glass) will take the vast majority of it. He or she will take a small percentage of the refund for his/herself, and then distribute the remainder to your creditors. But we’re trying to discharge the creditors, not give them any more of your money.

Now I’m not suggesting that you get your refund and blow it all at Best Buy. Just the opposite. I’m suggesting that you spend it on things that you need. Some examples would include: new set of tires, repairs to your car, paying your car insurance, catching up on the mortgage, etc. Because if you get a tax refund and spend it before filing for bankruptcy, the Trustee is going to want to know what you spent it on. If you say that you spent it on a new stereo, big screen tv, and a bunch of dvds, the Trustee is going to make the argument that you misspent the refund, and as a result defrauded your creditors. However, if you’re able to honestly tell the Trustee that the refund was spent on necessary items, you should be okay.

In a Chapter 7, I always suggest doing your taxes first so that you have a chance to spend the refund. Of course, people file Chapter 7 bankruptcies throughout the course of the year, not just tax season. What if you need to file in early November? Again, I normally suggest that if you are anticipating a large refund, to wait until the beginning of the new year so that you can do the taxes and get the refund. But if you can’t wait that long (because the creditors are starting to garnish your wages, or repossess your car), and it’s necessary to file the Chapter 7 immediately, then yes, there is a strong possibility that the Trustee is going to want the refund. But that would only be the one time; it’s not as if the Trustee can take refunds annually, unless you file a Chapter 13 bankruptcy.

When you are in a Chapter 13 repayment plan, you have the right to keep $600.00 of the total tax refund you (or the total of two plan payments, whichever is less) received from both federal and state returns combined. So in the example where you are expecting a $5,000.00 refund, you would keep $600.00, and $4,400.00 would go to the Trustee. Chapter 13s run from three to five years, so the Trustee would expect you to send additional refund money above $600.00 for each year you are in the bankruptcy.

But on the other hand, the Trustee isn’t the person who gets to decide whether or not you get a refund. That decision lies in your hands. Depending on what sort of deductions and/or exemptions you indicate on your tax forms, you may or may not get a refund each year. But getting a large refund in February doesn’t mean that the government has decided to be nice and give you extra money. It simply means that they took too much money out of your regular paychecks in taxes, and are now giving it back to you. That money was yours all along. It’s not additional money that you are now receiving; it’s what you would have received had you not taken all those deductions/exemptions in the first place, which means that you can always adjust your exemption/deduction status. You’ll receive less of a refund at the end of the year, but you’ll receive more per pay check throughout the year.

Or, if you are the type of person who insists on having a refund (because it’s the way you make sure to have some money at the end of each year in order to take care of certain expenses), then a Motion to Retain Tax Refunds can be filed. In doing so, you are basically asking the court’s permission to keep more than the normal $600.00. Usually the motion would state the amount that is anticipated and what you’d like to use it for. Again, typical examples would include: an unforeseen medical expense, car repair, new tires; or I’ve even drawn up motions where we ask to keep the refund to buy a new car.

So the filing of a bankruptcy doesn’t automatically mean that your tax refund is thrown out the window. It depends on the timing of the filing, and what kind of expenses you have that you can (legitimately) use the refund on. Either way, the best course of action to determine how to handle your refund money is by talking to an experienced St. Louis bankruptcy attorney. All phone calls and office consultations are free of charge.

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