What Happens to Tax Debt and Refunds During Bankruptcy?

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Debt comes in all forms. Unfortunately, that means tax debt is also a part of bankruptcy that often needs to be addressed. And, it can be complicated. Tax debt – and any tax refunds — are not straightforward when it comes to bankruptcy. It can vary depending on if you are filing for Chapter 7 or Chapter 13 bankruptcy, and the rules need to be closely followed.

Find out how tax debt is handled during bankruptcy proceedings, and why you need a bankruptcy attorney to help.

Tax Debt in Bankruptcy

Tax debt can be difficult to discharge during bankruptcies. If you are filing for Chapter 7 bankruptcy, the following minimum criteria must be met to discharge tax debt:

  • The debt is from federal or state income tax debt. Any tax debt accrued from fraud penalties or payroll taxes is not eligible.
  • You did not file a fraudulent return or commit tax evasion.
  • Your debt is at least three years old.
  • You filed a tax return at least two years before filing for bankruptcy.
  • The debt must be assessed by the IRS at least 240 days before filing for bankruptcy.

NOTE: These are complicated and nuanced rules require a detailed analysis and the acquisition of tax account transcripts to make the determination if your taxes may be discharged in bankruptcy. If the tax debt is dischargeable, it is eliminated by court order in the bankruptcy. In all cases, the most recent few years of tax obligations are not eligible for discharge.

If you are filing for Chapter 13 bankruptcy, you will need to repay your recent tax debt through your Chapter 13 repayment plan while it is possible taxes that meet the above criteria will be eliminated with no contribution or minor contributions from the Chapter 13 repayment plan.

Tax Refunds in Bankruptcy

Like tax debt, tax refunds can be complicated during bankruptcy proceedings.

Chapter 7

If you file for Chapter 7 bankruptcy, whether or not you can keep your tax refund depends on if you can mark your refund exempt. If you can, then you can typically keep the refund.

However, if you cannot mark the refund exempt, then the general rule is you can keep a pro-rata portion up to the day of filing for bankruptcy. For example, if you file for bankruptcy on July 24th, the 205th day of the year, you can expect the trustee to request 205/365 of your refund – or 56%.

This is further complicated by multiple years of returns owed. If you are likely or certain to receive a large tax refund, you must have thorough discussion with your bankruptcy attorneys as tax refund retention can be exceedingly complicated case-to-case.

Chapter 13

When filing for Chapter 13 bankruptcy, whether or not you can keep your refund depends on your repayment plan and the total amount you need to repay your creditors.

You may be able to mark refunds exempt that are certain to occur on the day of filing if you have exemptions available. This would include the current year’s refunds and prior years’ refunds due.

If you don’t have exemptions available, then it will depend on your specific case and your court-appointed trustee. However, you should expect to turn over future years’ tax refunds – in addition to your monthly repayment fees.

To protect your tax refund during the bankruptcy proceedings, your bankruptcy attorney may recommend adjusting the tax withholdings on your paychecks. Instead of paying higher taxes each pay period and getting a larger refund at the end of the year, you would get more back in your paychecks and less of a refund. If you don’t get a refund, you do not have anything to turn over to the court.

Best Practices

To avoid having to turn tax refunds over to the court, it’s essential to follow these tips from our bankruptcy attorneys:

  • As stated above, if filing for Chapter 13, you should adjust your withholdings to get more back in your paycheck and less of a refund.
  • If filing for Chapter 13, it’s essential to always consult with your bankruptcy attorney before spending any tax refund you may get.
  • You should also avoid spending any refund in a Chapter 7 or Chapter 13 bankruptcy case until you as the Debtor can discuss with your attorney and your attorney can confirm whether the trustee in your case will permit you to keep the refund.
  • It’s crucial to follow all guidelines set by your attorney. Failure to turn over a tax refund when required can prevent your debts from being discharged.

Let Us Help You

When you have questions about how your tax debt or tax refunds will be handled in bankruptcy, let our lawyers at The Law Offices of Alexzander C.J. Adams, P.C. help you review your options and possible outcomes. We work for you, the people, and not institutions. Contact us for a free case evaluation, or no-obligation consultation. We are dedicated to helping you overcome this small bump in the road and assisting you to get on with your life.

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