Tax Refunds and Bankruptcy

People that file bankruptcy between January and mid-April (during tax season) often ask what happens to their tax refund and what can they do to protect it. Today’s post discusses ways to protect your 2020 tax refund depending on if you have already received your refund (but not spent it) or are expecting a refund. 

Scenario 1: I received a tax refund, but still think I need to file bankruptcy in the future.  

If you have already received your refund and are still contemplating bankruptcy, you should call a bankruptcy attorney immediately. A competent bankruptcy attorney will be able to go over how to spend your tax refund before filing bankruptcy. Yes, in most cases you will want to spend it all before filing, you will want to make particular purchases, and you will need to KEEP THE RECEIPTS from those purchases. The Trustee will ask what you did with your refund and you will need documentation to back it up. You are converting your non-exempt item (the cash refund) into exempt items or items you can protect from creditors and able to keep after you file.  

So, what are examples of items I can spend my refund on? 

First be sure to use your refund on necessary expenses such as food, your mortgage/rent, and your car payment to make sure you’re current (if you plan on keeping these during the bankruptcy). If you need personal property, think of household furnishings and clothing. Generally acceptable items/purchases include: 

  • Car repairs 
  • Replacing appliances 
  • Furniture
  • Clothing
  • Medical or dental care 
  • IRA contribution-A tricky one, ask your attorney for more information. 
  • Paying insurance premiums-home or auto 
  • New vehicle-Another tricky one, make sure you consult your attorney before making a vehicle purchase.  
  • Stocking your freezer
  • Paying your bankruptcy attorney  

Did you see Jewelry, a PS5, collectibles, a jet ski, or other “fun stuff” on the list? NOPE. Those items are generally not ok to buy and are considered luxury goods. Worst case scenario is that the trustee will seize your luxury item and sell it and pay your creditors. If you have questions about a particular item or purchase, ask your attorney for guidance.  

What else not to do with your tax refund. 

Don’t pay back your friends or family! Sometimes paying back these types of debts can hurt you (and them) more than it helps. Under the bankruptcy code, each creditor is treated the same, whether it’s your mom or Visa. If you pay back your mom and not Visa, this can be seen as a preferential payment, which is not allowed.  

After you file bankruptcy, the Trustee will look to see if you paid any particular creditor to decide if any preferential payments were made. For family and friends (called “insiders” in the bankruptcy world) the Trustee can look back to a year before the filing. The Trustee can potentially undo these transactions and demand mom pay the funds you gave her into the bankruptcy estate. If you paid someone that isn’t an “insider”, in our example you paid your Visa card and nobody else, the Trustee can take those funds back as well.   

Scenario 2: I have not received a tax refund, but expect one, however I can’t wait to file a bankruptcy.  

If you do not fit into Scenario 1 and a bankruptcy filing is urgent, you may still be able to keep some (not all) of your tax refund. Common situations that lead to immediate filing include wage garnishment, foreclosure, or eviction proceedings. On the day you file bankruptcy, any asset you own is part of the bankruptcy estate. This includes the tax refunds that you have not even received yet. The only way to keep part of your tax return is to exempt it in your bankruptcy petition.  

In Kansas, under KSA 60-2315, the earned income credit (EIC) tax credit portion of your tax refund can be exempted from the bankruptcy estate and the non-EIC portion will need to be paid to the Trustee. You can only exempt one year of EIC. Most likely you will exempt your 2020 EIC, but if you have more than one year of unfiled taxes, you can select a different year to claim a larger EIC amount.  

Example: 

Kim files bankruptcy in Jan 2021. She has not filed taxes for 2019 or 2020 and eligible for EIC in both years. In 2019 she had 2 dependent children living with her but in 2020 she only had 1 dependent. She would want to exempt the EIC from 2019 because it is higher. The bankruptcy Trustee would be then entitled to the non-EIC portion of 2019 and both the EIC and the non-EIC portion of 2020. 

Scenario 3: You need to keep the entire refund for living expenses

In some cases it might be possible to file a Chapter 13 bankruptcy with a payment plan and pay back the refund over time that is not protected by law.  In that case you would figure out how much the bankruptcy trustee was entitled to and then propose to pay that back in a slightly reduced amount over a number of years.  This would allow you to retain the entire refund at the time you filed the bankruptcy so it could be used to help you cover your monthly expenses or cover a car repair or some other necessary expenses.  

Conclusion 

If you think you will file bankruptcy soon, give our office a call to discuss how to spend your tax refund and keep the most from your tax refund.  Our bankruptcy attorneys will be happy to give you a free consultation and cover all of your options.  We have offices in Wichita, Topeka, Lawrence, and Overland Park.  

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