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Bankruptcy and the Tax Refund

Posted by attorney Dorothy Bunce

It is shared among friends like a government secret - “you will forfeit your tax return" when you file bankruptcy. Like most secrets whispered over and over, there is a hint of truth and a lot of misinformation.

Your tax return is only the PAPERWORK you submit to the IRS. You know, the form 1040 and all the attaching Schedules and other forms." You always have to turn over a copy of your tax return paperwork when you file any form of bankruptcy because it is an important financial document that shows whether or not you are eligible to obtain the many benefits of bankruptcy. The exception is if you are one of the few people who do not have to file tax returns because your income is less than the minimum filing requirement.

It is the "tax refund" that often has to be forfeited when someone files bankruptcy. The refund is the check or the money that you expect will be direct deposited into your bank account. But not everyone that filed bankruptcy must forfeit this money.

Here is the untold truth about bankruptcy and the tax refund. In Bankruptcy, your right to receive a tax refund is considered to be like money you have saved in a bank. The amount you saved is calculated based on the date your bankruptcy is filed. Filing Bankruptcy on July 1 is halfway through the year, and if you file Bankruptcy on July 1, half of your tax refund saved for the next tax filing is vulnerable to being forfeited to the bankruptcy trustee. If you file bankruptcy on January 1, the entire year has passed and all of your tax refund is vulnerable to being taken by the bankruptcy trustee.

But if you can claim exemptions to protect your tax refund, you certainly ought to take advantage of these exemptions. If you fail to claim these exemptions, the bankruptcy trustee will gladly take the money because doing so is completely legal. After all, the job of a trustee is to collect money to distribute to your creditors, and not to protect your interests and be your attorney. The most common exemptions available to protect a tax refund are exemptions that protect the “Earned Income Credit" and the “wildcard" exemption. Understanding how these exemptions work are what makes hiring an attorney who specializes in bankruptcy law crucial.

Once a tax refund is paid out to you and you spend it, you no longer have this money saved up with the IRS. Any future tax refunds do not have to be turned over to the bankruptcy trustee except to the extent that money has been saved up for the follow tax year. So if you file bankruptcy after receiving the refund check and spend it on something that doesn't violate the bankruptcy laws, this tax refund money is yours. And in most instances, if you file bankruptcy in April, which is 4/12ths of the way through the year, the amount of your refund to be paid the following year won't be enough to make collecting it from you worthwhile to your bankruptcy trustee.

That is, unless you filed a Chapter 13. In Chapter 13, your Plan may state that every tax refund must be turned over as long as your case remains open.

You see, whether you will lose your tax refund in a bankruptcy isn’t something that involves a simple “yes" or “no" answer. Familiarity with the complexities of the unwritten rules of the bankruptcy courthouse can mean the difference between losing your tax refund or keeping some, most, or all of it. But you do always have to turn over a copy of that TAX RETURN in any case. Turning over the RETURN paperwork only hurts a little, while turning over a REFUND check can hurt a lot!

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