Bankruptcy and Tax Refunds

For many North Carolinians, annual tax refunds play a valuable role in the household budget. When contemplating bankruptcy, it's worth considering how the bankruptcy process interacts with the receipt of tax refund payments.

Simplest Solution?

The simplest solution, long term, is not to get a tax refund in the first place. A traditional refund is the result of excess withholding from paychecks over the year. This amounts to a loan to the government. One can avoid such a refund by adjusting withholdings, resulting in more money in the paycheck each pay day. While one might miss the annual lump payment, one still gets the same amount of money, but quicker and in way that is generally smoother for a future or current bankruptcy case. Unfortunately, this option isn't always available, especially if the refund is a result of certain refundable tax credits. When a refund is largely credits, there may already be no income tax being withheld.

Tax Refunds and Chapter 7 Bankruptcy

A tax refund is an asset, and therefore potentially subject to being used by the bankruptcy trustee to pay creditors in a North Carolina chapter 7 bankruptcy. However, it's frequently possible to protect this refund going into chapter 7. A few points are worth observing.

  1. Not knowing what your refund might be is a risky approach to chapter 7. It's difficult for a bankruptcy attorney to devise a strategy to protect an asset of unknown value.
  2. Depending on the size of the refund and other assets, it might be important to reduce it to cash before filing. Or it might not matter.
  3. Even the year isn't over yet, the entitlement to a refund after the year concludes might still be an asset in a chapter 7 bankruptcy.

In addition to asset protection considerations, knowing about anticipated refunds can be important for calculating the chapter 7 means test correctly, when determining income-based eligibility to file chapter 7. Also, some debtors may use part of a refund to pay costs of a bankruptcy case.

Tax Refunds and Chapter 13 Bankruptcy

All of the asset considerations of a chapter 7 bankruptcy also apply to a chapter 13 bankruptcy, as chapter 13 considers what would happen in a hypothetical chapter 7 as part of the best-interests-of-the-creditors test. The presence of a large refund before filing might result in a larger plan payment. Just as in chapter 7, many times exemptions will be available to protect normal size refunds and keep the plan payment down.

Whether or not a chapter 13 debtor must turnover ongoing tax refunds varies from court-to-court and case-to-case. The terms of a confirmed chapter 13 plan should answer the question of whether a refund must be turned over as a matter of course. However, even if the plan doesn't requirement payment of the refunds, and many plans do not, there may be a need to disclose the existence of the refund to the trustee. The trustee can then determine whether to seek a plan modification. Such a modified plan, if approved by the court, might require some or all of the return to paid into the plan as disposable income.

A distinction might be made between normal course tax refunds and exceptional refunds. As of the moment a bankruptcy case is filed, the bankruptcy debtor's finances come with them a certain on-going tax liability. If things stay the same, this might mean a $500 refund each of the next three years. It may be possible when drafting the original bankruptcy papers to take this on-going refund into account. This is especially the case for above median income debtors, whose means test calculation should reflect actual tax liability, not withheld taxes. Things get more interesting when there are exceptional refunds. One must ask, what changed to cause the refund to get much larger? The circumstances that lead to new refunds are too numerous to list. Some may legitimately be disposable income, while many are directly related to an expense such that the new net income is ultimately not disposable.

Having said all of the above, I would come back to the simplest point: minimizing over-witholding is the easiest way to avoid difficult questions about tax refunds in later years of chapter 13 bankruptcy cases.

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Knightdale Attorney Erich Fabricius represents clients in bankruptcy, consumer debt litigation, and in small business matters. He is licensed to practice law in North Carolina. His blog posts consider matters related to debt, bankruptcy, litigation, and other legal issues in North Carolina.

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This blog post is made available for educational and informational purposes only and to promote a general understanding of the law, and not to provide specific legal advice. Use of this blog does not create an attorney-client relationship. Reading this post is not a substitute for obtaining legal advice based on the unique facts of your situation from an attorney licensed to practice law in your state. No representation is made regarding the currentness of the information contained in this post. Examples that may be provided in this post are merely for illustrative purposes; the results in your case may be different and no results are guaranteed.