Tax Refunds And Bankruptcy, What Can You Do With A Tax Refund?

2010 is upon us and pretty soon we all will be receiving our W-2′s and 1099′s. For a person planning to or anticipating filing bankruptcy, you need to know that your Income Tax Refund is likely at risk of being seized by the Bankruptcy Trustee. Reason being, most states have no, or a very limited, exemption to protect a persons tax refund. (See Learning the Lingo (Issue 1), Exempt vs. Non-Exempt In Bankruptcy). If you file bankruptcy, have not received and spent your tax refund at the time you file bankruptcy, your tax refund will, most likely, be taken by the bankruptcy trustee.

Around this time of year, the number 1 question from clients is this: can I keep my tax refund? In Colorado there is no exemption to protect a tax refund. If you file bankruptcy before you have received your tax refund, the bankruptcy trustee will take it. However, if you receive your tax refund and spend it improperly, the trustee may object to the discharge of your bankruptcy (that is very bad). If you are planning bankruptcy, you must be aware of improperly dissipating assets, fraudulent transfer, and insider payments (e.g. using your tax refund to pay back your mother the money she loaned) all of which can jeopardize your bankruptcy.

So, how can you spend your tax refund before filing bankruptcy? You can certainly use your refund to pay for necessary living expenses; mortgage/rent, gas in car, groceries, etc. No one is going to object to your bankruptcy if you used your tax refund to live. Also, you can use your tax refund to pay for your bankruptcy attorney; easily more than 50% of bankruptcies filed between February and June are funded by an individuals’ tax refund. Beyond those limited expense categories, you enter a grey area (once you enter the grey area, you really should hire an attorney to help you successfully navigate it).

Remember this phrase: “Repair is fair, to improve is reproved” ©. (yes, I own that phrase. Granted, ‘reprove’ is a bit archaic, but you try to come up with a definitionally appropriate word that rhymes with improve). So you don’t need to look it up; reprove means to criticize, condemn, show disapproval. The next expense that is ok in bankruptcy is necessary repairs. For example, if your vehicle needs new tires (because the existing tires are bald), you may use your tax refund to purchase new tires; however, do not purchase a set of 18 inch chrome rims along with the tires. Generally, you may use your tax refund to make household and vehicle repairs without raising an objection. Tip; take “before” pictures of the thing being repaired so you can demonstrate to the bankruptcy trustee the need. In addition, repairs should satisfy a health and safety concern.

The next level of use falls into exemption planning. Exemption planning consists of moving non-exempt assets (e.g. tax refund) into exempt assets (e.g. IRA). Exemption planning is beyond the scope of this blog entry and entails significant risk to a bankruptcy client if done improperly. Bankruptcy courts are split as to what is allowed in exemption planning and can affect the client’s ability to receive her bankruptcy discharge. If your tax refund is going to be more than you can eat up with living expenses, attorney fees, and repairs; you need to hire an experienced bankruptcy attorney who is willing to help you achieve the most successful bankruptcy your circumstances will allow.