In bankruptcy cases, tax refunds earned during the year in which someone files for bankruptcy can be taken by a trustee who oversees the case, even if the tax refund doesn’t arrive for months after the case is filed. The applicable rule states that however far you are into a year, you are deemed to have earned that same percentage of your income tax refund for the year.
For example, if you file your case on September 30, 2022, then you are filing exactly 9 months into the year, or 75% of the way through the year. So, the court treats 75% of your 2022 tax refund as having been earned as of the date you filed for bankruptcy. So, when you receive your tax return in 2023, you may have to send 75% of your tax refund to your case trustee. For someone who files a Chapter 7 case on September 30, 2022, the discharge will likely be entered around January 1, 2023. Your bankruptcy case may be “over” because you’ve received a discharge of your debts; however, you still have a duty to turn over that 75% of your federal and state income tax refunds when you receive them.
Caveats to the general rule
Of course, you would rather not have to turn over that tax refund. There are various caveats to the general rule as stated above.
- Earned Income Credit (“EIC”) does not count as a tax refund. In Missouri, neither does Additional Child Tax Credit (“ACTC”) count. So, you’ll get to keep any amount for those items shown on your tax return.
- If the amount of the funds that must be turned over to the trustee is minimal, then the trustee may simply allow you to keep all of the refund because the small amount the trustee would receive isn’t worth doing all of the work to process it. For example, let’s say you filed on September 30, 2022, so 75% of the way through the year. Assume your total refund is $6,000. At first blush, it appears you would need to turn over $4,500 to your trustee. But, let’s assume $5,000 of the tax refund is EIC, meaning that you get to keep that. That leaves $1,000 remaining. Of that $1,000, 75% or $750 was earned before filing. You would definitely get to keep the 25% or $250 that you earned in 2022 after you filed bankruptcy. In this case, the trustee’s portion is $750, which is a pretty small amount. If there were no other assets that your trustee can gather to use to pay back your creditors, there is a good chance that your trustee will tell you to just keep the $750. As a general rule, most Chapter 7 trustees will not do the work to process property that has value of under $1,500.
What happens if the tax refund is substantial?
The key is to make the portion of your refund you must turn over to be as small as possible. But, what if you normally get pretty big tax refunds that would need to be turned over to a trustee? Let’s assume in the above example that only $3,000 of the $6,000 refund was EIC, and that the trustee demands you turn over $2,250 of the tax refund. In that case you would have to turn over the $2,250. In this scenario, we would likely have met with the client in mid-September to do all of the paperwork for filing. We would likely have recommended to the client that he or she fill out a new W-4 form at work to claim “EXEMPT” from federal & state tax withholdings for the remainder of 2022. So, if the client would normally have received $3,000 in tax refunds for 2022, those amounts would be reduced significantly if no taxes were withheld for October, November and December 2022. There is a good chance that claiming exempt from withholdings for the last 3 months of the year would nearly eliminate the tax refund. The client would in essence receive the tax refund in the form of higher paychecks for October, November and December, thereby getting to keep the money that would have come later in the form of a tax refund. Two important things to remember about adjusting your W-4 form to claim “EXEMPT” from withholding:
First, you must write the word “EXEMPT” at the bottom of the W-4 form rather than doing the calculation to determine how many exemptions to claim.
Second, pursuant to recent changes by the IRS, your withholdings will revert back to normal after January 1 arrives. This is a good thing because for most bankruptcy filers, only the tax refund for the year in which the case is filed is subject to the rule that income taxes earned as of the date of filing must be turned over. For Chapter 13 cases, the rule is a bit more complicated, and there is a chance that your income tax refund in the second through 4th years of your case would need to be turned over to your trustee. But, it is much less likely.
For more information about tax refunds and bankruptcy visit us at www.kansascitybankruptcy.com or call for a free consultation with an attorney at 913-422-0909. At W M Law, we are “Here to Help”.