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Can I Keep My Income Tax Refund If I File a Chapter 7 Bankruptcy?

Whether you can keep your tax refund in a “straight bankruptcy” is mostly a matter of timing.

To make sense of this, first here’s some essential background information.

As of the time your Chapter 7 bankruptcy is filed, everything you own legally becomes part of your “bankruptcy estate.” In most cases, all of those “estate” assets stay in your possession and you remain the owner because those assets are “exempt,” or protected.

That “bankruptcy estate” includes not only your tangible possessions, but also intangible assets—ones that you can’t physically touch, such as money owed and not yet paid to you. If your Chapter 7 case is filed at a time when a tax refund is owed to you, that anticipated refund is an intangible asset of your “estate,” although one that may be protected by an exemption.

So timing determines whether a tax refund is part of your “bankruptcy estate,” and, to the extent that it is, whether you can keep part or all of it is determined by your exemptions.

Timing

What does an income tax refund usually consist of?—your overpayment of payroll withholdings to the IRS and/or the Oregon Department of Revenue during the course of the tax year. So, right after your last paycheck of the year is processed and the last withholding taken from your salary or wages, you have made your last overpayment related to that year’s refund. As a result, even though nobody knows the amount of your refund until your tax return is prepared a few weeks or months later, for bankruptcy purposes that refund is all yours as of January 1 of the new year.

So if your Chapter 7 case is filed after the end of the year but before you have received and spent your tax refund, that refund belongs to your “bankruptcy estate.” That means that the trustee can take it from you if it is not exempt, or can keep the portion that is not exempt. To be clear, this is also true if you have received the refund but still have the check itself or the money from the refund check when your case is filed.

You can avoid having the refund belong to your “bankruptcy estate” by filing your tax return and receiving and appropriately spending the refund before your Chapter 7 case is filed. DO NOT do this without very specific advice from your attorney. The bankruptcy trustee is very interested in any money you receive and precisely how you spend it before filing bankruptcy. It is all too easy to cause major problems if this is not done very carefully.

Exemption

If your bankruptcy is filed so that the refund is an asset of your “estate,” whether or not it is exempt depends on how large the refund is and how much of an exemption is available.

The exemption in Oregon for cash and money owed is quite modest—only $400 per person, or $800 for a married couple filing a joint case. But even that is reduced by any cash or money you have in any checking or savings accounts at the time your case is filed, which you also need to protect. So you can see that the exemption is not very helpful if you are expecting a relatively large refund.

However, to the extent that your refund results from the Earned Income Credit, in Oregon that part of the refund is completely exempt. For many people that can be a major part of their refund, and in fact is often is the entire reason they are getting the refund. So it may be able to protect part or all of your refund.

Even if the refund, or a part of it, is not exempt, the Chapter 7 trustee may still not claim it if he or she determines the amount available is not enough to open an “asset case.” That is, after subtracting any exempt portion, the remaining amount might be small enough that the trustee decides that the benefit of dividing that amount among your creditors is outweighed by the effort and cost involved. It’s just too small to be worth the hassle. You might hear the trustee say at your meeting with him or her that the amount is “insufficient for a meaningful distribution to the creditors.” This threshold amount varies over time, and from one trustee to another, so this is something we will discuss carefully with you if it applies to your case.

Warning

Although we’re focusing now on this because it’s tax season, the same principles apply year-round. Frankly, it can be a little harder to wrap your brain around this as applied to filing a bankruptcy later in the year, after getting and spending your prior year’s refund and long before you start thinking about getting the current year’s refund the following spring. But if you think about it, 3/4ths of the way through the year you’ve had 3/4ths of a year of tax withholdings deducted from your paychecks and forwarded by your employer to the tax authorities. So, assuming that about the same amounts are withheld throughout the year, for bankruptcy purposes about 3/4ths of your refund had likely accrued by 3/4ths of the way through the year. So a bankruptcy filed on, say October 1st, needs to take that into account. Most Chapter 7 trustees don’t push this issue much until the last quarter of the year, when that much more of the refunds have accrued. But be sure to tell us if you have a history of relatively large tax refunds or are anticipating a refund the following year.