Special rules in bankruptcy, part 3: tax refunds

This is the third in a series of blog articles about some of the special bankruptcy rules that govern certain types of property. Those who seek a fresh start in bankruptcy need careful advice about what they will need to exempt from claims of creditors. Generally those seeking a fresh start in bankruptcy end up having to surrender property that has net value greater than the dollar amounts they can claim as exempt, or else they have to pay that value to a trustee for the benefit of creditors.

Those assets include tax refunds not only for a previous tax year, but also some part of a refund that will be claimed and paid the year following the bankruptcy filing. It does not matter that the tax return which gives rise to the claim for a refund has not been filed.

Including refunds not yet received for previous years are not hard to understand. In bankruptcy, all right to claim and receive money from someone else is an asset that must be listed, and if not exempted, will have to be surrendered. If I am entitled to a refund now, or as soon as I file a tax return for a past year, that is really no different than any other “account receivable” or debt that is owed me.

But the refund that I will not receive until after this year is over, when I file a return next year? Why this is also a current asset is more easily explained when one considers what a refund is. A tax refund is generated by overpayment of taxes. Courts have been unanimous that some part of the refund that will be generated next year is an asset in bankruptcy, even if the exact amount is not yet known. The portion of that refund is caused by taxes overpaid before a bankruptcy filing is thus a bankruptcy asset.

Where courts differ is how to calculate what percentage of the refund needs to be declared and exempted. One approach is to apply a pro-rata date method, so that if I file bankruptcy 1/3 of the way through this year, then 1/3 of the refund is what I need to exempt in order to keep. Other approaches look at where the payments that are being refunded came from, or how the tax was generated.

What is important is to know about this and include this consideration in your planning. Bankruptcy is a potentially complex process. Knowledge of the special rules and how they are applied to in any case is essential. We have the experience and knowledge to help.

Part 1: Protecting Social Security Benefits

Part 2: Protecting Retirement Funds and IRA’s

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