Tax Refunds and Chapter 7 Bankruptcy

A topic often discussed with a bankruptcy attorney is the manner in which a bankruptcy will affect tax returns. Many people assume that future refunds will be off-set against what they owe. Others think that their tax return will be withheld for a long period of time.

When a Chapter 7 petitions are filed, the courts will usually appoint trustees whose jobs entail collecting assets and turning those assets into cash. The cash is then used to pay creditors. Assets that can be reached by a trustee will be referred to as the estate. This estate is created the day a petition is filed in court. The estate contains everything a debtor owns the day the Chapter 7 petition is filed. The courts have established that a portion or all of a tax refund can be held as an asset even if the debtor has not filed for or received their refund until after the bankruptcy was filed.

Most courts will divide tax refunds proportionally to the point during the tax year when the case is filed. For instance, if the petition is filed on July 1, 2012, the halfway point during the year, 50 percent of the tax refund may become the property of the estate. Another example would be: If the petition is filed in January of 2012, the entire tax refund may be included as property of the estate. The impact it will have on a tax return will depend on many factors.

It is advisable for those who are getting a large refund to review what is on their W-4 forms. If large refunds are attributed to earned income credit, they should consider filing W-5 forms. A W-5 form is just like a W-4 form but it calculates the probable earned income credit. A W-5 form will adjust the withholding accordingly. There will be a refund, but it won’t be as much as it usually is; however, there may be more take home pay by using this method.

In Phoenix, attorneys are used to hearing their clients get upset about the fact that the court might be taking their tax refunds. It is best not to concentrate on that, but to plan to reduce the impact as much as possible. The W-5 withholding form is an example of planning.

Clients should discuss all their concerns with their lawyer before they file; however, the decision to file should not rest on the dismay of their tax refund being taken away. If they thought of it as someone settling all of their debts for the price of their tax refund, they would jump at the chance to do so. It certainly would be a good deal for most people who are drowning in debt.

The estate only includes what the debtor currently owns on the day the case is filed. Tax refunds for future years will not be affected. They will be able to keep all future refunds. However, if there are past refunds that have not yet been paid to them prior to filing the Chapter 7 petition, they will be affected.

Many people in Phoenix would like to use their tax refunds to pay off attorney fees and court costs. In Arizona, tax returns are not exempt, so a lawyer should be consulted before a petition is filed. Planning ahead by anticipating the impact that the court will have on their tax return is something that can be discussed during the consultation.