The short answer is – with proper legal planning and timing, you will likely be able to keep all or most of your tax refund check even when you file for Chapter 7 bankruptcy.
But, with bad planning and poor timing, the bankruptcy trustee may use the entire amount to pay off creditors.
Timing is crucial, and you should get legal advice before you file either your tax return or bankruptcy. At Kain+ Henehan, we are happy to help with those questions.
But first, here are some factors that determine if you can keep your tax refund.
Reasons for Bankruptcy
Every family has financial ups and downs. And sometimes, no matter how much you try, you just get farther behind, and it seems impossible to catch up.
You have a hard enough time paying for food, rent, clothing, kids, and basic expenses. There is no way you can pay off the creditors who are now calling non-stop about balances that grow larger every day.
And unfortunately, many reasons people choose bankruptcy are for life-changing events out of their control. More than 60% of people who take Chapter 7 bankruptcy say enormous and unplanned medical expenses are the reason. The other top reasons are job loss, divorce or separation, illness, and unexpected events like theft or natural disasters. Without insurance, many of these events leave people with overwhelming debts.
Bankruptcy is a difficult decision at a stressful time of their lives. No one is meant to live with smothering debt or financial ruin. People often turn to bankruptcy for protection to get a federally protected fresh start.
What is Bankruptcy?
Bankruptcy is a set of federal laws that provide for the elimination or reduction of some debts or give a timeline for repaying other debts, usually at a reduced amount. The bankruptcy court gives protection to people when they can longer pay their bills.
And while the bankruptcy laws have changed over the years, Congress was granted the right to make uniform bankruptcy laws by the U.S. Consitution.
What is the Difference Between Chapter 7 and Chapter 13?
Federal bankruptcy laws offer individuals two different types of bankruptcies, Chapter 7 and Chapter 13.
The simplistic difference is that Chapter 7 sells your assets and uses that money to pay the creditors. In Chapter 13, there is a court-approved plan to pay back your creditors over time and keep your assets. In Chapter 7, most of your assets are gone. In Chapter 13, the goal is for you to keep your assets. Depending on what assets you have, with the advice of a compassionate bankruptcy attorney, you can choose what option is best for you.
Chapter 7 is the more popular plan, with more than 80% of Minnesota bankruptcies choosing Chapter 7.
Chapter 7 is often called a liquidation or straight bankruptcy. The bankruptcy court appoints a trustee responsible for selling your assets and paying off your creditors. But only your non-exempt assets can be sold. After the trustee sells the non-exempt assets, they pay off the creditors, usually at a severely reduced amount, and discharge your outstanding unsecured debts. However, some debts cannot be discharged, such as student loans and taxes.
Chapter 13 is designed for debtors who want to keep their assets but need help getting back on their feet financially. According to the trustee-approved plan, the debtor pays back the creditors over three to five years. Creditors are usually paid back at a deep discount.
Minnesota or Federal Exemption Plan – Your Choice
In a Chapter 7 bankruptcy, the trustee can only sell non-exempt assets to pay off creditors. The trustee is prohibited from selling exempt assets.
And the U.S Bankruptcy Court is a federal court that follows federal laws of the U.S. Bankruptcy Code.
However, to protect their citizens, several states passed laws defining what property is exempted from collection or sale in bankruptcies to protect their citizens. And in most of those states, you must use the state exemption rules. For example, if you have a bankruptcy in Iowa, you must use the Iowa exemptions and not the federal exemptions.
But Minnesota is one of the few states that lets you choose between using the federal or state exemption rules. However, you must use those exemption rules for all assets once you decide.
The choice between state and federal exemptions can significantly impact your bankruptcy, depending upon your circumstances. For example, do you rent or have a house with a mortgage? Do you have receivables and cash flow?
This is one area where you should get some qualified advice from a bankruptcy attorney.
So, Can You Keep Your Tax Refund?
The critical factor is timing.
Remember that the trustee is under an obligation to sell your assets and pay your creditors. And the money from your tax return is an asset.
The Tax Return is in the Bank
If you file for Chapter 7, all the assets you own on the date of filing become part of the bankruptcy estate, except for exempted assets. If you received your refund and it is sitting in your bank account on the day of the bankruptcy filing, it is part of the bankruptcy estate.
You Spent the Tax Return
Suppose you get your refund and spend it before filing for bankruptcy. In that case, it is generally not part of the bankruptcy estate. And, if you spend the return on everyday expenses like food, school, and rent, there should be no issues.
But if you give the money to your brother or otherwise improperly tried to move the money out of the estate, the trustee might rule that you must replace the funds.
You Filed for Your Tax Return Before Filing Bankruptcy
This is the worst planning. Any tax refunds that are due and owing to you become part of the bankruptcy estate.
For example, suppose you filed your bankruptcy on June 30, 2022, but haven’t yet filed your 2021 taxes. Your 2021 tax refund is receivable to you and becomes an asset of the bankruptcy estate. And it gets worse. Since you filed your bankruptcy halfway through 2022, 50% of your 2022 refund is now also an asset of the estate.
What Can You Do
Many strategies can help. For example, your tax refund is money you have overpaid to the IRS. If you know you will be filing a bankruptcy in the future, you can have your employer withhold only enough to pay the taxes at the end of the year. You will receive more money in your paycheck, and your refund will be minimal. Even if it becomes part of the estate, the impact is negligible.
Another strategy may be to elect the federal exemption rules, depending upon your circumstances. The federal exemption rules have a “wildcard exemption” that the Minnesota exemption rules do not. Assuming your circumstances qualify, the federal wildcard rule can generally be applied to any asset. The wildcard exemption has a $1,225 minimum and a $12,725 maximum.
Your Next Best Steps
Filing for bankruptcy should not be embarrassing. It is a federally protected way to start over without the crushing debt that often was no fault of yours, but rather through unexpected circumstances.
At Kain + Henehan, we approach the subject of bankruptcy with a compassionate guiding hand. As qualified Minnesota bankruptcy attorneys, bankruptcy due to medical and other unforeseen debts is something we deal with every day.
We know how difficult it can be to ask for help. If you are overwhelmed by debts and considering bankruptcy, let us help you with your next best steps. Bankruptcy law is complex, but this is what we do. And if you have a tax refund coming, let’s talk about the best strategy for that also.
We help families like yours get a fresh start in their new financial life. Let us help you, too.
Call our office today at 612-438-8006 or go online to schedule a free consultation.