Income Tax Refunds in Bankruptcy-Chapter 7

Posted by on June 23, 2015 under Bankruptcy Blog | Comments are off for this article

If you’re filing a “straight bankruptcy” case, how do you keep your income tax refund?

Keeping tax refunds is all about timing. You can generally keep your refund but absolutely have to play it right, following rules that at first may not make sense. It is all too easy to mess this up, so you truly should have your attorney guide you through it, applying your unique circumstances to your local laws and practices. But here are the general principles at play.

Let’s start with some background to make sense of this:

• From the bankruptcy system’s perspective, a Chapter 7 case focuses on assets—determining whether you get to keep everything you own or not. That’s why it’s called the “liquidation” chapter. Most of the time you do get to keep everything, but sometimes some of it gets “liquated”—taken from you and turned by your bankruptcy trustee into cash, which then gets paid to your creditors.
• So where does your tax refund fit into this—is it is an asset that your trustee can take from you? That mostly depends on your timing.
• Everything you own or have a right to at the moment your Chapter 7 bankruptcy case is filed becomes your “bankruptcy estate.”
• That “estate” includes both your tangible assets and also intangible ones. One kind of intangible asset is a debt owed to you. A tax refund can be such an intangible asset of your “bankruptcy estate.”

The timing of the filing of your Chapter 7 case determines whether a tax refund is part of your “bankruptcy estate” and therefore could potentially be taken from you:

• An income tax refund is considered your asset as of the time of the last payroll withholding of the year being considered (so for this calendar (2015), the last withholding would be from your last paycheck in December and your employer would forward that money to the taxing authority in the beginning of January, 2016). That’s because as of that time, the full amount of that refund has accrued. Even though until you prepare your tax returns nobody knows the amount of your refund—or even whether you will be receiving one at all—for bankruptcy purposes, the anticipated tax refund is legally all yours as of the very beginning of the next year. And what’s yours is part of your “bankruptcy estate.”
• So IF you file after the beginning of the year but before receiving and appropriately spending the refund, that refund is part of your “bankruptcy estate” and is at least at risk of being taken from you. Again, this is true even if you have no idea how much that refund will be, or even whether you are entitled to one.
• BUT, if you DO receive and appropriately spend the refund before your Chapter 7 case is filed, then the refund is gone and is no longer your asset, and so is no longer part of your “bankruptcy estate.” Your trustee has no claim to it.

Even if your tax refund IS part of your “bankruptcy estate,” it will not be taken from you if it is exempt:

• Although theoretically it’s safest to file your Chapter 7 case when your tax refund is not part of your “estate”—such as after you receive and appropriately spend it beforehand, sometimes you don’t have that much flexibility about when you file your bankruptcy. Then especially it’s critical to get good legal advice about whether that refund will be exempt based on the local law applicable to the case.
• Usually, you get to keep most or all of your “estate” because it’s “exempt”—protected. In the same way, tax refunds are often exempt, depending on the amount of the refund and the exemption that’s applicable to it.
• Some states have specific exemptions applicable to certain parts of the tax refund, or laws that exclude them from the bankruptcy estate altogether, particularly for the Child Tax Credit or the Earned Income Tax Credit.

Even if a tax refund, or some portion of it, is not exempt, sometimes the Chapter 7 trustee may still NOT want it:

• The trustee may decide that the amount the “estate” would get—the refund by itself or in conjunction with any other non-exempt asset(s)—is not enough in value to justify creating an “asset case.” The amount of refund to be collected may be too small to justify the administrative cost involved to collect and distribute it. You might hear the trustee say that the amount of the refund is “insufficient for a meaningful distribution to the creditors.”
• What that “insufficient” amount is differs from one court to another, and often even from one trustee to another, so this is another specific area where you need the guidance of an experienced attorney.
•  Caution: if the trustee is already collecting any other assets as part of the “estate,” then most likely he or she will want every dollar of your tax refunds that are not exempt.

Interesting Historical and Personal Facts about Income Taxes

Posted by on June 11, 2015 under Bankruptcy Blog | Comments are off for this article

Did You Know…

• The first income tax was enacted during the Civil War, but it expired a few years after the war ended.
• The first peacetime income tax was passed in 1894, an effort of the Populists to get the wealthy to pay a greater share of the cost of the national government. It was a two percent tax on incomes over $4,000 (worth about $108,000 in today’s dollars), which at the time affected only about the top two percent of wage earners.
• The next year the U.S. Supreme Court overturned this law as unconstitutional, in a 5-4 decision. Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 161 (1895).
• A constitutional amendment to allow an income tax was proposed by the Republican President William Howard Taft, and the resolution for that amendment was passed by Congress with the Republicans in control of both the Senate and the House of Representatives.
• The entire Sixteenth Amendment states: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.”
• After the required 3/4ths of state legislatures (36 of the 48 then-existing states) ratified it, on February 25, 1913 the Sixteenth Amendment was proclaimed ratified and became part of the Constitution.

So February 25, 2013 was the 100 year anniversary of the income tax becoming constitutional. Funny, I don’t remember any anniversary celebrations!

The MOST Interesting Facts

As the blogs in this series on taxes have been describing, bankruptcy can help you with income tax debts in a variety of ways. If it’s true that in life the facts that are most interesting to you are those that are going to help your pocketbook, then check out the following facts:

• Some income taxes CAN be forever discharged (legally written off).
• Taxes can be discharged under either Chapter 7 or Chapter 13, depending on which is right for you based on your other circumstances.
• The protection from creditors you receive by filing bankruptcy—the “automatic stay”—protects you from the IRS (and other tax creditors) like any other creditor.
• In a Chapter 13 payment plan, that protection can last for 3 to 5 years, giving you that much time to pay taxes that can’t be discharged.
• Even if you owe a tax that can’t be discharged, a Chapter 7 bankruptcy can put you in a much better position afterwards either to enter into a payment plan or negotiate a settlement.
• Chapter 13 usually stops accruing interest and penalties on tax debts that can’t be discharged, reducing the overall amount you have to pay.
• If you owe a number of years of income taxes, Chapter 13 is often an excellent tool because all your taxes—as well as all your other debts—are handled in one tidy package.

Taxes and bankruptcy DO mix, often greatly in your favor.