Anticipated Federal or state income tax refunds usually become quite a hot topic during tax filing season, as many unsuspecting bankruptcy filers are caught off guard when they fail to account for this important and often substantial asset. Frequently novice, inexperienced attorneys will fail to account for this type of asset in their clients’ bankruptcy schedules, placing the refund in jeopardy of being taken by the trustee and used to satisfy the claims of creditors. This can cause a financial disaster for a client who was relying and counting on a large Federal tax refund to pay for necessaries of life or other important expenses.
So why all the fuss about tax refunds? If tax refunds are small, then they are usually of no interest to the bankruptcy trustee because the cost of administration (collecting the refund and distributing it to various creditors) does not make it feasible to collect and distribute the fund among creditors. But if the refund is large, then the trustee will definitely have an interest in it and the question will become determining whether the refund is protect by your applicable exemptions. If the refund is protected, then you can keep it. If or to the extent that the refund is not protected, then you will have to give it up and the trustee will take it and divided it up between your creditors.
The reason that tax refunds frequently become an issue is that novice practitioners often don’t realize that one of your potential and often significant assets in a bankruptcy case is a possible tax refund that may be owing by the government to you, so they overlook it and don’t account for it in doing the calculations for your exemptions. If the refund were accounted for, then you and your attorney would be able to plan for how to protect it using your exemptions. But if you failed to account for it, you and your attorney may end up using all of your available exemptions to protect other assets, leaving little or no exemptions left to protect the tax refund. In that case, you will lose some or all of your tax refund.
Therefore, when filing for bankruptcy be sure to mention to your attorney whether you anticipate receiving any income tax refund. If you have an experienced bankruptcy attorney, he or she will discuss this with you and account for it. But if you have an attorney does not discuss this issue, be sure to bring it up yourself. If you are unsure whether you will receive a tax refund, always err on the side of caution. List an anticipated tax refund in the amount that you may possibly receive and make sure that you have sufficient exemptions left to claim the tax refund as exempt, that is, protect it with your available bankruptcy exemptions.
And it is not only during tax season that you must be careful about anticipated tax refunds and making sure they are protected in bankruptcy. The same issue could come up any time during the year, or years later. If you have filed for an extension, your taxes may not even be due and you may not have even thought about any tax refund. But you may be owed a refund. If you have not filed taxes for a couple of years and need to file, you may be entitled to a refund for those years. Always make sure that you and your attorney have discussed the issue of possible tax refunds before you file your case.