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How Bankruptcy Handles a Pending Income Tax Refund under Chapter 13

If you file a Chapter 13 bankruptcy while you have a tax refund coming, you can usually put that refund money to a good purpose.

In our last blog post we wrote about keeping your tax refund in a Chapter 7 “straight bankruptcy.” Chapter 13 can be even more creative.

Bankruptcy as “Adjustment of Debts”

Chapter 7 is a “liquidation,” but one which, for most people, does not result in anything they own being “liquidated.” That’s because everything they own is protected through property “exemptions.”

Same thing with income tax refunds. A tax refund that is owed to you at the time your Chapter 7 case is filed (but which has not yet been received and spent) is considered an asset for bankruptcy purposes. But the pending refund is often exempt, so that you get to keep it.

Chapter 13 “adjustment of debts” is quite different than Chapter 7. The focus instead is on putting together and executing a plan to pay part of what you owe to creditors. The plan often revolves around paying special creditors in order to achieve a particular purpose—such as to save your home or pay overdue income taxes—and to do so while being protected from your creditors.

How tax refunds owed to you at the time of your Chapter 13 filing are treated turns on some of the key principles of Chapter 13 law.

The “Disposable Income” Principle

Under Chapter 13 you pay your creditors for a certain period of time—usually between 3 and 5 years, the length depending on your income and other factors—while paying only as much as you can afford to pay them. You pay creditors your disposable income—your income minus your reasonable and necessary expenses.

So if a month or so after you file your Chapter 13 case you receive an anticipated tax refund, it is considered income that should go to your creditors, UNLESS you have a legitimate reasonable and necessary expense that the refunds should be spent on instead.

Candidly, most people who file bankruptcy have been financially struggling for many months, and usually for years. And so they have usually long deferred spending money on one or more important expenses. Common examples are vehicle repairs and medical and dental expenses.

So if you are owed tax refund(s) at the time your Chapter 13 case is filed, you can usually get permission (from the Chapter 13 trustee, or in some places from the bankruptcy court itself) to use the refund when it arrives for your intended purpose. You may be required to document that you did indeed spend it for that purpose.

The “Best Interest” Principle

Under Chapter 13 you are required to pay your creditors at least as much as they would have been paid had you filed a Chapter 7 case instead.

You may think that’s easy because in most Chapter 7 cases most creditors get nothing, whereas in Chapter 13 cases you are obligated to pay creditors all you can afford to pay them over a period of time. The reality is that even under Chapter 13 your “general unsecured” creditors may well get little or nothing because all your disposable income is going to pay other higher priority debts. Under the “best interest” principle, under Chapter 13 you must pay a certain minimum amount to your “general unsecured” creditors, that amount being what they would have received in a Chapter 7 liquidation.

Recall that creditors under Chapter 7 receive nothing if everything that you own is “exempt.” But if you have a tax refund that is partially or entirely not exempt, then your Chapter 13 plan would have to earmark at least that “non-exempt” amount of money to your creditors during the entire life of the plan.

Avoid These Principles by Waiting to File the Chapter 13 Case Until After Getting and Spending the Refund

If you have flexibility in the timing of your Chapter 13 case, just submit your tax returns quickly so that you can receive and appropriately spend your refund before filing your Chapter 13 case.

Be sure to get legal guidance about how to “appropriately” spend the refund money. That’s because the bankruptcy system is quite sensitive and inquisitive about financial transactions during the months before a bankruptcy filing. Particularly be cautious about paying money to favored creditors, buying assets that would not be protected, and in general not squandering the money.

Conclusion

Your pending tax refund can usually be protected when you file a Chapter 13 bankruptcy case. You can get permission to use it for a reasonable and necessary expense. Or you can often earmark it within your Chapter 13 plan to pay an urgent debt, such as the arrearage on vehicle loan, home mortgage, or child support. Or you can just avoid the whole issue by waiting to file the Chapter 13 case until after you have received and appropriately spent the refund. So, as long as you are getting solid legal guidance about the best way for you to deal with your unique situation, it is highly unlikely that your pending tax refund would be taken from you and used for a purpose that is not beneficial to you.