Written by attorney Christopher H. Ariano

Will I Receive A Prorated Tax Refund in Chapter 7 Bankruptcy?

I have said before, if you are expecting a substantial tax refund, you need to plan your chapter 7 bankruptcy filing around receiving that refund, it order to prevent its inclusion in the bankruptcy estate. I recently had a client question this point, because her previous attorney had suggested that she need not worry about the date of filing, as her return would simply be prorated.

First of all, let me say flat out that this is bad advice. The idea of the prorated tax return is not as appealing as it sounds and in most cases (especially those bankruptcies filed around tax season) it makes sense to time your bankruptcy accordingly. Below I will explain why.

I have already explained in a previous post that your income tax refund is generally considered part of the bankruptcy estate. The concept of calendar proration is used to determine the portion of the tax refund that can be taken by the trustee. This is how it works:

Consider the scenario in which you want to file for chapter 7 bankruptcy protection and are concerned with how it will affect your tax refund for 2010 withholdings, that you will receive once you file your taxes in 2011.

If you file bankruptcy in 2010 (assume that this was after you already received and spent your refund from 2009 withholdings), the trustee is entitled to a prorated portion of the tax refund you will receive in 2011. This is calculated as a percentage of calendar days, based on your filing date. That is, if you filed bankruptcy on April 15 (the 105thday of the year) the trustee is entitled to a percent of your tax refund equal to 105/365. This amount corresponds to the portion of the tax refund that is attributable to pre-petition withholdings.

Another problem with this scenario, in addition to losing money to the bankruptcy estate, is that the trustee will likely take the entire refund upon filing in 2011. Then, only after some extended period of time and many phone calls, will you receive your tax refund (if you are lucky).

I should also point out that if you must file near the end of the year, you can attempt to reduce your withholdings for the remaining months, to reduce the refund you receive when you file taxes. This can help prevent the inclusion of additional funds as part of the bankruptcy estate.

If you file bankruptcy in the first few months of 2011, before you file and receive that year's tax refund, any tax refund you receive or may subsequently receive that year is considered part of the bankruptcy estate. This is because, at the time of filing, you are owed the refund and thus it is considered a (non-exempt) asset.

If you wait to file bankruptcy in 2011 until you have received (and spent) your 2011 tax refund (for 2010 withholdings), the asset no longer exists and thus cannot be included in the bankruptcy estate.

If you have been following this example closely, you may be thinking that if you file in 2011, shouldn't the trustee be entitled to a prorated portion of your 2012 tax refund? Yup. However, if you file bankruptcy early in 2011, the prorated portion of your 2012 refund will be small (that is, if the trustee attempts to recover it at all).

To sum it up, I generally recommend that my clients file bankruptcy early in the year, though after they have received and spent their tax return for that year. However, there are always confounding variables that may complicate the situation. If you are facing wage garnishments or home foreclosure, the idea of losing your tax refund may be trivial.

As always, these situations are complicated and I recommend you speak with a qualified bankruptcy attorney before making any decisions regarding when to file. If you live in the Phoenix area and would like to speak with a licensed bankruptcy attorney, feel free to give me a call. I offer free bankruptcy consultations in both Phoenix and Tucson.

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