The treatment of Chapter 13 “adjustment of debts” is both better and worse than under Chapter 7. Here’s how.
Our last blog was about how to keep a tax refund that you are entitled to but have not received as of when your Chapter 7 “straight bankruptcy” case is filed, and particularly how a change in Oregon law a few months ago has made that easier. Because of that law change anyone who receives legal advice from a competent bankruptcy attorney should be able to protect their tax refunds.
Chapter 13—the often very powerful 3-to-5-year program for dealing with special kinds of debts—presents a very different set of issues.
Pending Tax Refunds
Back to Chapter 7 for a moment, it fixates for most asset purposes on the moment in time that your case is filed. It looks at what you own then, and what portion of that is protected, that is, covered by exemptions. Income tax refunds that are pending—have legally accrued but not yet been paid to you—are assets for Chapter 7 purposes. In its practical effect, the Oregon law change referred to above greatly increased the exemption for tax refunds, so that tax refunds are now protected in most Chapter 7 cases.
Chapter 13 also focuses on what you own on the date of filing the case, and so the same law change applies to it as well. But while in a Chapter 7 case a pending tax refund that is not exempt must be surrendered to the bankruptcy trustee (in the rare situations that would still happen), under Chapter 13 you can generally keep non-exempt assets as long as you pay appropriately into your plan to do so. The new increased exemption amount thus may reduce how much you must pay to your creditors in a Chapter 13 case.
Chapter 13’s Focus on Your Disposable Income
But because Chapter 13 is designed to require you to pay your creditors as much as you reasonably can over a 3-to-5-year period, it looks beyond your assets to your monthly disposable income. As a result the money you receive from a tax refund after your case is filed has to be accounted for—either earmarked for and spent on an explicitly designated and approved purpose, or paid to the Chapter 13 trustee to be distributed to creditors as your court-approved plan designates.
Spending Your Pending Refund on A Designated Purpose
If at the time you file your Chapter 13 case you have a specific very important expense that you would like to spend your tax refund on once it arrives, you may well be able to get permission to use the refund, or a part of it, on that expense. The permission needs to come from the bankruptcy judge, who must be convinced of the importance of the expense, and that it can’t be taken care of though your normal monthly budget. Examples are a vehicle repair enabling you to commute to work, or the uninsured portion of upcoming medical or dental expenses.
Paying Your Pending Tax Refund Into Your Plan
If you don’t have such an immediate expense, you may be required to pay all or part of the refund to the Chapter 13 trustee. But that can often be beneficial to you. In many cases you have some control over where that money would go, often to places where you would want it to go anyway.
For example, your Chapter 13 plan could be put together in such a way that most of your tax refund would go to catch up on a child support arrearage (for the intangible benefits that may provide you) or to pay down a vehicle loan (to build equity and/or pay it off faster).
Future Year Tax Refunds
Chapter 13 focuses on your disposable income during the entire course of your case, which includes tax refunds during that whole period. The prospect of paying your tax refunds each year to the Chapter 13 trustee may not sound very appealing but can often actually serve your best interests in the following ways:
If you are used to getting relatively large tax refunds, your paycheck tax withholdings need to be adjusted so that you are not giving the feds and the state an interest-free loan every year. Instead you can use that money throughout the year for your regular living expenses. This would eliminate or reduce the size of the tax refunds going to the trustee, getting rid of or at least minimizing this issue.
If a year or two into your Chapter 13 case you are entitled to a tax refund and you have an important special expense that you would like to spend it on, you may be able to get permission to do so. It’s important to contact your attorney early—your argument would be much harder to make if you’ve already spent the refund money without permission and are trying to justify your actions after the fact.
Even if your refunds simply go to the trustee during the course of your case to be distributed as designated by your court-approved plan, often that extra money is extremely helpful. It may well finish your case faster, pay particularly important creditors more quickly, or even enable you to pay the plan off within the mandatory maximum 5-year period—thus preventing your case from being thrown out after all the effort you’ve put into it.