Tax Returns and Bankruptcy

Every fall and early winter potential bankruptcy filers and their attorneys face the same question. Should we file this case before we receive our tax refund - and risk losing it - or wait to file until after the refund is received and spent? Tax refunds can be non-exempt in a bankruptcy and it is possible that a bankruptcy filer may lose all or part of his refund if he files bankruptcy too soon.

There are so many factors that are involved in weighing the benefits of filing bankruptcy now vs. waiting and getting the refund and THEN filing bankruptcy. For example, a person being garnished may ultimately lose more money by delaying filing then she would be filing a bankruptcy, stopping her garnishment, and forfeiting his refund. It all depends on varying factors.

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Earned income tax credit received in a refund is exempt in a bankruptcy so this should not be a reason for delaying a bankruptcy filing. If nearly all of a tax refund is earned income tax credit then there is no need to wait to file bankruptcy to protect the refund. If a potential bankruptcy filer is expecting tax refund of 7000 dollars, 5000 dollars of which is earned income tax credit, he will need to spend the entire 7000 dollars to protect the 2000 dollar non-exempt portion. It is also important to note that while earned income is exempt in a bankruptcy filing, the child tax credit is not.

What state you live in also makes a difference. Washington bankruptcy filers have more liberal exemption laws that usually allow them to keep refunds without a problem. Also different trustees in different cities have different policies on how they choose when to administer or not administer tax refunds.

In a chapter 13 where you live may decide whether or not you can keep the refund or have to turn it over to the chapter 13 trustee. The refund may need to be factored into the bankruptcy budget so filers can keep it. We often advise our clients in certain cities to increase their exemptions to lower or eliminate their refunds so they can keep these funds for their families' needs.

I read this weekend that the IRS will not even start processing refunds for those taking itemized deductions until after the middle of February. The many rules and nuances surrounding the decision of when to file a bankruptcy with an incoming tax refund are largely learned knowledge and not written down anywhere. This is yet another reason why it is critical to have an attorney experienced in this area. Losing money - often thousands of dollars - when you are already in a struggling financial state is a costly mistake that can be avoided with the right direction and counsel.

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