Tax Refunds and Bankruptcy

March 10, 2011

By: David M. Serafin

When deciding to file for bankruptcy, many clients this particular time of year who overpaid their tax liability to the IRS and/or State of Colorado (and who do not owe any past due tax arrears which can intercepted) will receive a tax refund. In my Denver, Colorado based bankruptcy and tax law practice, I always recommend that my clients first receive the tax refund, spend it down, and then file for bankruptcy – in this order.

The alternative could prove disasterous: if you file for bankruptcy while still expecting to receive a tax refund, the trustee will request that the funds be turned over to the bankruptcy estate, so that unsecured creditors can be paid something. And if you’ve already spent down these funds by the time of the 341 Meeting of Creditors, the best case scenario is that you pay back this amount in monthly installments. (In Colorado, my experience has been that chapter 7 trustees – versus chapter 13 trustees - are more aggressive about compelling turnover of the tax refund, likely because chapter 13 debtors are already making plan payments, usually in part to unsecured creditors, for 36 to 60 months.)

Assuming you receive your tax refund before filing for bankruptcy, the question arises as to how to spend down the tax refund. I always recommend that clients spend down the tax refund on “necessaries” such as a mortgage or car payment, food, utilities, insurance, student loan payment (if under $600), contribution to IRA or ERISA qualified retirement account, or even attorney’s fees and court costs for your bankruptcy.

Conversely, you do not want to use the tax refund to pay any debts owed to the majority of unsecured creditors. Even though technically allowed by the Bankruptcy Code for payments of lower amounts, why make another credit card payment as you’re going to discharge this debt anyways? (The exception being a single credit card with a low balance if you and the creditor agree outside the bankruptcy to voluntarily pay this debt back.) And you do not want to pay back any debts owed to a family member as the bankruptcy trustee may seek to invalidate an avoidable preferential or fraudulent transfer.

Of course, you may not have the luxury of waiting to receive a tax refund if you face an imminent foreclosure, car repossession, wage garnishment or civil judgment, and need to immediately file. A typical client will receive a tax refund of anywhere from $100 to $4,000. So, as a matter of pre-bankruptcy planning, it will be necessary to weigh your overall financial situation to determine when you should file. As an Aurora, Colorado debt elimination attorney, I always urge clients to realize that the debt being discharged still will vastly exceed any tax refund lost to the bankruptcy trustee.