Bankruptcy and Income Tax Refunds: What You Need to Know

March 16th, 2017 by Bunch & Brock

This year, both the Easter Bunny and the Tax Man will make their rounds after the traditional April 15 tax filing deadline. The date can’t be on a weekend, and Emancipation Day is observed in Washington, D.C., on April 17. These circumstances push the cutoff to Tuesday, April 18, giving taxpayers three days more than usual to submit their income taxes.

If you have recently filed for bankruptcy or are contemplating it in the near future, you may have questions about how it affects your taxes. Let’s take a brief look.

Tax Refunds Post-Bankruptcy

Bankruptcy requires the filing of two tax returns – one for the individual (typically Form 1040) and one for the bankruptcy estate (Form 1041). The bankruptcy trustee files for the estate, which is usually court-appointed for Chapter 7 debtors and the debtor himself for Chapter 11 actions. Once you file a petition for bankruptcy, any assets you own become part of the bankruptcy estate. A tax refund is considered an asset, because it derives from wages that were earned before the bankruptcy. If it can’t be protected with federal or Kentucky state “wildcard” exemptions, it can be seized by the trustee and given to your creditors to pay your debt. As cash that does not have to be liquidated and sold, refunds are easy to deal with and are generally not overlooked by the trustee unless the amount is too small to off-set the associated administrative costs.

Tax Refunds Pre-Bankruptcy

Timing is everything, so if you are considering bankruptcy, spend your refund before filing. It may sound counterintuitive, but if you want to have any control over what happens to it, you have to spend it. Doing so is permissible as long as you use it on certain necessary items such as:

  • Mortgage payments or rent
  • Home repair and maintenance
  • Homeowners’ association fees
  • Utilities
  • Clothes
  • Food
  • Insurance premiums
  • Car payments
  • Car repair and maintenance
  • Educational expenses.

It’s important to limit spending your return to approved expenses. If you use the money to buy luxury items or even to repay a creditor, your bankruptcy discharge could be denied on bad faith grounds. Since bankruptcy protection is intended to release you from your debts, the trustee can (and will) legitimately question why you spent money on frivolous objects rather than to pay some of your bills. And while it may seem like a good idea to pay back a creditor, the trustee may conclude that your payment was preferential. Favoring one creditor over another is not allowed.

The smaller the refund, the better for people considering bankruptcy. It’s better to have a little more money in each paycheck then having to face handing your refund over to the trustee. Adjust the exemptions on your W-4 to have only the necessary taxes withheld.

The Lexington bankruptcy attorneys at Bunch & Brock know how to protect assets in bankruptcy and how a refund can be spent without landing you on the wrong side of the trustee. If you wish to learn more about how our firm can be of assistance to you, or you want to learn more about this topic, we encourage you to contact us by calling 859-254-5522 or filling out this online form