Bankruptcy Horror Story #4:
The Chapter 7 Trustee Took My Tax Refunds
The Chapter 7 Trustee can take your Federal and State tax refunds depending on the exemption used in Schedule C, the amount of the exemption available in Schedule C, making sure no refund is received, and the timing of the bankruptcy filing. The Trustee can assert an interests in a debtor’s tax refund in the year the case is filed and the following tax year.
This is why it is important to speak to an experienced bankruptcy attorney, who can make sure the proper exemption is used and time the filing of the case to protect all past and future tax refunds. I would estimate that a Trustee will take at least one to two debtor’s tax refunds during each session the Trustee conducts their examinations, which is usually 15-20 cases.
If a debtor has equity in their property, they will likely use the 704 exemption to protect the equity in their property from the Trustee liquidating the property. The problem is that under the 704 exemption, a debtor cannot protect their tax refund. Moreover, some debtors do not have property, but have other assets like bank accounts and cars that need to be protected, so there is no wildcard protection under the 703 exemption to protect the tax refund. Remember, the Trustee can take an interest in the refund in the year before filing and the refund in the current year.
How does a debtor protect their refunds if they cannot use an exemption in schedule C?
The debtor is entitled to a tax refund in the prior year. For example, the debtor files their 2021 taxes and is expecting a $5,000 refund, but needs to file a bankruptcy in 2022. How does a debtor make sure they receive their $5,000 refund and not have to turn it over to the Chapter 7 Trustee? It is very simple: the debtor must receive the refunds prior to filing the Chapter 7 case. Once the debtor receives the refunds, they are not property of the estate (this assumes the debtor is not holding the money and spent the refund). If the case is filed, but the debtor has not received the funds or the taxes have not been filed yet, the refund becomes part of the bankruptcy estate and must be turned over to the Trustee. Solution: if the debtor is expecting to receive a tax refund, my recommendation is to wait until the debtor receives the refund and then files the case. The debtor can even use the tax refund for attorney fees to file the bankruptcy.
The debtor files the case latter in the year and expects a tax refund when they file their taxes next year. For example, the debtor files a Chapter 7 bankruptcy on September 1, 2022; the 2021 taxes show the debtor received a tax refund of $10,000. Since the case was filed in September 2022, three-fourths of the 2022 refund was earned prior to filing, so the Trustee will ask if the debtor anticipates the same tax refund when they file the taxes in 2022. If the answer is yes, the Trustee will demand $7,500 of the refund when it is received. This assumes the debtor cannot exemption future tax returns under 703 or 704 exemptions. Solution: upon review of the huge tax refund in 2021, the debtor should change their dependents on their pay stubs to 9. This will increase the money the debtor takes home each month and stop federal withholdings. The result allows the debtor to take home more money each month to live, and reduces the amount of the tax refund the following year, as the debtor is paying no taxes. Hence, the refund the debtor needs to turn over to the Trustee will be much lower than the $7,500, or the debtor may not have to turn over any money, once the Trustee reviews the pay stub. This can also be down for a self-employed debtor: they pay less in taxes from the date they decide to file bankruptcy to reduce the refund.
Many debtors depend on their refunds to survive, so it is important to protect them from the Chapter 7 Trustee. It is imperative to meet with an experienced bankruptcy attorney, who can analyze your tax refunds and provide the appropriate advice so the debtor can keep the refunds after filing bankruptcy.