INCOME TAX REFUNDS IS PROPERTY OF BANKRUPTCY ESTATE UNLESS EXEMPT

Let’s say that you decide to file for Chapter 7 relief this month to discharge $100,000 of hospital bills and credit card debt. You anticipate that you will have an income tax refund claim of $10,000. What is the bankruptcy treatment of this refund? If your Chapter 7 case is filed before you file your 2013 tax returns, the entire $10,000 becomes a receivable which is one of your personal assets, just like a car. Your schedule B must disclose the $10,000 as an expected income tax refund. If you want to keep the $10,000, and I presume that you do, you must exempt the entire $10,000 in schedule C. If you do not exempt the $10,000, you must give the $10,000 to the Chapter 7 trustee when you receive the refund from the IRS. But given the fact that the USA is bankrupt, you might as well kiss your refund goodbye.

If you are not able to exempt the $10,000 as a receivable this month, you might consider delaying your Chapter 7 filing until after you file your tax returns and actually receive the $10,000. When you receive the $10,000, you can use that money for the mortgage and other household expenses. In other words, use it up so that it is no longer a receivable or an asset. Or, you can use the $10,000 to buy a life insurance with cash value of the same amount and use the applicable exemption of Section 703.140(b)(8). These steps are pre bankruptcy planning activities which are allowed by bankruptcy law.

But what if you filed your Chapter 7 petition on December 1, 2012 and you forgot that you had a $10,000 refund for 2012? Your 341 A hearing is tomorrow. At the hearing, the Chapter 7 trustee asks you if you expect a tax refund for 2012. You scratch your head and finally say “yeah, I think a have a little bit coming in.” The trustee presses you further “how much is a little bit?” “Just a little $10,000” you manage to whisper out with tears streaming down your cheeks. “Did you say $10,000? Well, I own 91.66% of that $10,000 because that refund corresponds to 11 months of your income in 2012. So, as soon as you get that money from Uncle Sam, cut me a check for $9,166” the trustee says to you. Is it too late to save your refund? No. You can still save it. Your lawyer is going to tell the trustee that he is going to amend schedule B to show the expected refund and C to exempt the money so that the trustee will back off. But mind you, your lawyer can only take this course of action if you still have an applicable exemption. If you do not have an exemption to use, you will have to pay the trustee $9,166 when you receive your refund.

What if you argue that you filed a joint tax return with your wife who has not filed a joint bankruptcy with you and that your income for the entire year of 2012 was only $500? There was no federal income tax withheld from your income. This is a valid argument because if you had practically no income for 2012, all of the refund actually belongs to your wife. State law defines the nature and extent of a debtor’s interest in property. So whether or not this argument will hold water depends on where you reside. If you live here in California which is a community property state, your wife’s refund is community property, so the refund also belongs to you as community property. In California, the fact that you earned nothing for 2012 is irrelevant, unless you have a prenuptial agreement. If you have a pre-nuptial agreement, the $10,000 belongs to your wife as her separate property and so the trustee cannot take it. If you do not live in a community property state, like Indiana, your wife will keep the refund.

Lawrence Bautista Yang is a graduate of Georgetown University Law Center and has been in law practice for thirty years.  He specializes in bankruptcy, business and civil litigation and has handled more than five thousand successful bankruptcy cases in California.  He speaks Mandarin and Fujien and looks forward to discussing your case with you personally.  Please call (626) 284-1142 for an appointment at 1000 S Fremont Ave Bldg A-1 Suite 1125 Unit 58 Alhambra, CA 91803.