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Can One Protect Their Tax Refund During Bankruptcy?

The following post is part of our Law Student Blog Writing Project, and is authored by Jessie Smith, a law student from the University of Kentucky.

Bankruptcy in Northern Kentucky Series

Taxation is something few think about during most of the year, absent the occasional article in the paper or segment on the news concerning the potential for tax reform. However, during the latter portion of the year, particularly between the New Year Holiday and April 15, otherwise known as “Tax Day,” taxes are a topic that come to the forefront of most working Americans’ minds. Although most do not look forward to the prospect of “filing taxes,” many can expect a refund for the amount they have overpaid through the year. For those in the midst of bankruptcy, or considering filing for bankruptcy, a natural concern that arises is what may happen to their tax refund. Although everyone’s circumstances vary, and those that find themselves in this position should seek out legal counsel, this blog post aims to provide a general answer to that question.

Can One’s Tax Refund Be Protected During Bankruptcy, Or Is It Subject To Seizure?

When an individual files for bankruptcy in Northern Kentucky, the vast majority of that person’s assets (the “non-exempt” assets) become part of what is referred to as the “bankruptcy estate.” The “bankruptcy estate” is defined by the U.S. Bankruptcy Code in 11 U.S.C. § 541. Section 541 defines the estate in sweeping terms, and, under most circumstances, one’s tax refund will be considered part of the bankruptcy estate. Whether one’s tax refund becomes part of the bankruptcy estate depends on a variety of factors, including the timing of the filing of bankruptcy, the year in which the income for which the refund is given was earned, and under what Chapter of bankruptcy one files, as well as how one chooses to utilize their “exemptions.”

The best way by which to illustrate the above is by way of example. Hypothetically, if a “debtor” were to file Chapter 7 bankruptcy in January of 2017, and were to subsequently receive a refund for the 2016 tax year, then that money will become part of the bankruptcy estate. Many may find this result somewhat confusing, since the tax refund is received after filing for bankruptcy. The underlying reasoning is grounded upon the period of time in which the money was earned and paid to the IRS; since the money was earned, and taxes on that income were to paid to the IRS, prior to bankruptcy, then the money one receives in the form of a tax refund as the result of any overpayment in taxes is viewed as though it was received throughout the previous tax year, as opposed to after filing for bankruptcy. As one source puts it, the way in which the law views this scenario is somewhat analogous to a savings account – the money overpaid in taxes for the 2016 tax year is “saved” by the IRS, just as one would place funds in savings, and the subsequent tax refund is similar to a “withdrawal.” Thus, under this hypothetical situation, although the debtor does not, in reality, receive the funds until after filing for bankruptcy, the money was earned and taxes paid prior to the filing, and will therefore likely be swept into the bankruptcy estate.

Another example arises when one files for bankruptcy and receives a tax refund for the same year. The following facts are illustrious of this hypothetical scenario: debtor files for bankruptcy in June of 2017, and subsequently receives a tax refund for the 2017 tax year in April of 2018. The question arises: does the tax refund get swept into the bankruptcy estate, as was the result under the immediately preceding set of facts? The answer is “yes” and “no.”

Here, the tax refund will be divided into two separate and distinct groups, the first being that portion of the refund attributable to income earned prior to filing for bankruptcy, and the second being that portion attributable to money made after the filing. The first group (that portion of the tax refund that is based on income earned before filing) is subject to being swept into the bankruptcy estate, while the second group (that portion of the tax refund that is based on income earned subsequent to filing) will likely escape the clutches of the estate. In other words, the amount of the tax refund that is calculated based on income earned prior to June of 2017 will become part of the estate, while the amount attributable to income earned subsequent to June of 2017 may be protected.

Another example provides some clarity with respect to a third, commonly seen situation. Assume debtor files for bankruptcy in December of 2016, and later receives a tax refund for the 2017 tax year. The concern that immediately comes to mind is whether the 2017 tax refund will be protected, or whether it will be subject to seizure. Here, the debtor will most likely get to retain the full amount of the tax refund, because all the income upon which the taxes were assessed was earned subsequent to filing for bankruptcy. In other words, the entire amount of taxes overpaid for the 2017 tax year were paid after filing for bankruptcy, and would thus generally escape being swept into the bankruptcy estate.

A final wrinkle that may be a concern for some is what happens to their tax refund in the context of a Chapter 13, as opposed to a Chapter 7, bankruptcy. The answer is largely grounded in the legal ramifications associated with filing for one type of bankruptcy over the other. When a debtor files bankruptcy under Chapter 7, the bankruptcy trustee takes possession of all of the debtor’s non-exempt property and/or assets, liquidates them (hence the term often used to refer to Chapter 7 bankruptcies, “Chapter 7 Liquidation”), and distributes the cash to the debtor’s creditors. Generally speaking, after the liquidation and subsequent distribution occurs, the debtor is “discharged” of all debts incurred prior to the bankruptcy filing. Under Chapter 13, on the other hand, a debtor repays their debts through utilization of their income, and may retain some of their assets. The period of time in which a debtor makes payments toward their debts is often referred to as a “repayment plan,” and typically lasts three to five years. Once the repayment plan is completed, the debtor’s debts are “discharged.” However, the critical difference between Chapter 7 and Chapter 13 bankruptcies in the context of retention of one’s tax refunds is centered around what is called “disposable income.” To put it in very general, broad terms, under a Chapter 13 plan, one’s “necessary and reasonable” expenses (i.e., generally, those expenses required to live, including, but not necessarily limited to, food, clothing, shelter, etc.) are subtracted from their regular income, and the resulting figure is known as the debtor’s “disposable income.” Most often, when a debtor files a Chapter 13 bankruptcy, and files a repayment plan with the court, tax refunds are not considered in the debtor’s income, and is thus not utilized in calculating the debtor’s necessary and reasonable expenses and disposable income. Thus, when a Chapter 13 debtor receives a tax refund, the amount received is most often considered “disposable income,” since the repayment plan accounts for the debtor’s regular income, regular expenses, etc., but does not factor in the additional funds a debtor will receive when given a tax refund. To put it more simply, the tax refund is, in a way, considered “extra money,” money that the debtor does not need to pay for their “necessary and reasonable” expenses; therefore, it is considered “disposable income,” and will be used to pay the debtor’s debts during the course of the repayment plan. Generally speaking, unless there is some “necessary and reasonable” expense that has not been taken into account by the repayment plan, then the chances of a debtor retaining their tax refund throughout the repayment plan period in a Chapter 13 bankruptcy is slim.

Are There Other Ways One Can Protect Their Tax Refund In The Midst Of Bankruptcy? Can Tax Refunds Be Utilized For The Payment Of Legal Fees Rendered In Filing Bankruptcy?

Although options are varied, many facing bankruptcy may think of paying legal fees through utilization of one’s tax refund as a means of protecting their refund during bankruptcy. For those considering such an option, it should be noted that others have pursued the same means of protecting their tax refund in the past. To determine the feasibility of this option, the following case law will be discussed.

In In re Hunter, the United States Bankruptcy Court for the District of Kansas was faced with the question of whether the assignment of a debtor’s tax refunds to their attorney as a method by which to pay legal fees would be protected, or swept into the bankruptcy estate. The particular circumstances are as follows: the debtors executed an assignment, operation of which allowed for their attorney to receive the pre-petition portion of their tax refunds as a flat-fee retainer in exchange for legal services rendered in filing for Chapter 7 bankruptcy. The bankruptcy trustees moved the court for an order forcing the pre-petition portion of the debtors’ tax refunds into the bankruptcy estate.

In support of their motion, the trustees made three primary arguments. The first argument the trustees set forth was predicated on 11 U.S.C. § 544(a), which, generally, provides for the avoidance of “any transfer of property of the debtor or any obligation incurred” under certain circumstances. Those particular circumstances in this case, and from the point of view of the trustees, was that the debtors could not “assign what [was] an essentially undivided and unliquidated expectant interest based upon a notional ‘accrual’ date.” Secondly, the trustees argued that the “debtors [were] required to marshal away from that part of the refund to which the estate [was] entitled.” Finally, the trustees were of the view that assign that portion of their tax refund attributable to pre-petition earnings “‘burden[ed]’ the creditors by effectively forcing them to pay the debtor’s attorneys’ fees and that this burdensome effect render[ed] the assignments fraudulent transfers done for the purpose of hindering or delaying the debtors’ creditors.” The debtors, on the other hand, made one simple argument: “an assignment of pre-petition tax refunds for payment of a flat fee is no different than a debtor paying an attorney a flat fee in cash; the result in either event is that the payment does not become property of the estate,” they argued.

The court largely agreed with the debtors. The court looked to statutory and case law in reaching its conclusion, drawing upon 11 U.S.C. § 330(a)(1), United States Trustee v. Lamie, In re Wagers, and In re Carson. Drawing upon all the previously identified law, the court determined that a “flat-fee retainer assigned for work done incident to filing a chapter 7 does not become property of the estate”; rather, “the assignment of an anticipated tax refund as part of or all of a flat-fee retainer is enforceable against the estate, at least to the extent of the amount of the flat fee.” The court finally concluded: “the benefits . . . to the debtors and to their creditors of having chapter 7 debtors well represented to outweigh the relatively small detriment that these assignments may work on the creditors. The assignments of these debtors’ expectancy interests in their tax refunds, limited as they are by the amount of the flat fees owed and by the amount of the refund that would be determined attributable to the estate are valid and enforceable. They do not significantly differ from a cash retainer payment that depletes the debtor’s resources before she files a case. So long as the fees are not fraudulent or excessive, there is no basis for the Trustees to recover them.”

It is important to keep in mind that different courts are held and bound to differing rules of law, depending on the jurisdiction. Although the results reached in In re Hunter may seem encouraging, the results reached there are not necessarily applicable in other jurisdictions. As always, it is important to speak to counsel regarding one’s own personal circumstances before coming to any determinations on how best to proceed.

Editor’s note: In the Covington Division of the Eastern District of Kentucky Federal Court, where all Northern Kentucky bankruptcies are heard, the Court and Trustees regularly allow debtors to use their tax refunds to pay for the bankruptcy attorney’s fees.

Conclusion

Depending on a variety of factors, some of which have been discussed above, a debtor facing the possibility of filing bankruptcy may have some options when it comes to possible retention of their anticipated tax refunds. However, there are a wide array of considerations that must be kept in mind when discussing bankruptcy. Although this post has focused primarily on what many consider to be the most common types of individual, consumer bankruptcies (that is, Chapter 7 and Chapter 13), one may consider Chapter 11 under certain circumstances, as well. Another consideration that was not addressed here involves whether one even qualifies for Chapter 7, or would be pushed into a Chapter 13. Such a determination is based on many factors, one of which is referred to in the bankruptcy arena as the “Means Test.” These considerations are briefly mentioned here to illustrate that the general overview provided above is by no means exhaustive or authoritative, to simply demonstrate that everyone’s circumstances vary, and, depending upon those circumstances, one option may be more appealing than another. Ultimately, however, certain debtors may feel somewhat more comfortable traversing the obstacles of bankruptcy with the knowledge that they may be able to, in one way or another, protect an anticipated tax refund.

If you’re considering using your tax refund to file a bankruptcy, call Lawrence & Associates! We’ve been helping people in Northern Kentucky keep their tax refunds for more than a decade. We’re Working Hard for the Working Class, and we want to help you!