Tax season is just weeks away, and many people are currently pulling together their finances in preparation for filing. We all understand that taxes are necessary, but the thought of filing a return can feel overwhelming for those who are already struggling. Because of this, many people question whether or not they should file their taxes if they consider bankruptcy. You may have heard that filing for Chapter 7 or 13 bankruptcy will protect tax refunds, but that is only sometimes the case. This month we explore how bankruptcy and taxes affect each other.
Tax Refunds in Bankruptcy
A tax refund is considered an asset in both Chapter 7 and Chapter 13 bankruptcy filing, and the timing of the refund is not relevant. In other words, there is no distinction between a refund you have already received and one you expect to receive – for the purposes of bankruptcy, the refund is an asset either way.
That being said, Florida statutes do place tax refunds in the “exempt” category. The only caveat is that you may be ineligible for the exemption if you owe child support or spousal support. Your tax refund may also be protected with Florida’s Wildcard exemption. The best strategy is to discuss your options with your Trustee or bankruptcy attorney.
Did You Know? Bankruptcies filed in Florida are subject to state bankruptcy laws, not federal ones.
Protecting your Refund: Chapter 7
Florida residents who file bankruptcy during tax season may wonder how to report the tax refund they have just received. As discussed above, either the refund or Wildcard exemption are likely to protect the refund from garnishment. However, there are still some best practices to consider if you don’t want to raise any suspicion.
Spend your refund: It is best to file for bankruptcy after you have received your tax refund. Spend your refund on living expenses such as your mortgage or rent, medical expenses, clothing, or food. Do not use your refund as a downpayment on a new sports car.
Ask your bankruptcy attorney if the tax refund can be applied to legal fees and costs. These strategies for spending your refund have been deemed appropriate in bankruptcy cases as neither action involves fraud, such as trying to avoid paying a debt.
Adjust withholding amounts: If you are due a significant refund because of dollar amounts deducted from each paycheck, adjust your tax withholding level. This tip is appropriate in the earlier parts of the year but won’t help much in the later months.
Remember, if the tax refund lands in your bank account, it is considered an asset. Ask your attorney if depositing the money into a retirement account would work for your situation.
Protecting Tax Refunds: Chapter 13
When filing for Chapter 13, individuals must protect their refund by applying for an exemption or using it for living expenses before filing. If preventative action is not taken, the money will go to creditors.
When in Chapter 13 three-to-five-year repayment plan, individuals are required to contribute all disposable income to the program. The Trustee can retain the refund if your specific arrangement contributes less than 100% to creditors. Creditors will be entitled to the same percentage of your total disposable income, including the tax refund.
The Trustee may permit you to keep the refund, primarily if an unexpected need arises or if your ability to afford basic living expenses has changed. However, in most cases, the Trustee will compel you to contribute the tax refund as part of the Chapter 13 repayment plan. Practically speaking, one of the only true preventive methods to protect your refund in Chapter 13 is to adjust tax withholding to minimize a tax refund. The fewer the number of dollars in the refund, the less there is for the Trustee to take.
If you are considering an adjustment to your tax withholding, make sure it is done before filing for bankruptcy to prevent the action from appearing to be an attempt to hide bankruptcy income that should be used to repay creditors.
The best way to understand the relationship between bankruptcy and tax refunds is to work with an experienced bankruptcy attorney.
Richard V. Ellis is a trusted Sarasota bankruptcy attorney who has helped area residents navigate the system for decades.