Keep a Tax Refund After Filing Chapter 13 Bankruptcy

Keeping a tax refund after filing a Chapter 13 bankruptcy case is commonly done in Massachusetts, and should be allowed across the country.

Dana Wilkinson just wrote here at Bankruptcy Law Network of the two-fold analysis that Chapter 13 bankruptcy law performs on a tax refund.  The first analysis is what she calls the “equity” test.  It looks at the expected refund as an asset, prorated as of the filing date, and whether it can be protected (“exempted”) under applicable bankruptcy law.  The unprotected amount of the tax refund must be paid to the trustee, although one gets to pay this in small monthly amounts over the length of the case.

The second analysis is the “income” test.  A Chapter 13 debtor, whose income is under the median for her household size,  must pay to the trustee the surplus after paying for reasonable living expenses.  A large tax refund received every year has the appearance of a surplus.  Many Chapter 13 trustees expect it. 

This is wrong. We all know it’s wrong. You know it’s wrong. It’s wrong because that tax refund is never saved.Of course it’s not saved.  It’s needed for busted furnaces and broken water heaters and worn out transmissions and such.  Those tax refunds are always spent.

The trick is to be certain that both the refund and its spending both appear on the income and expense schedules I and J.  It’s easy to do.  Divide the expected tax refund by 12 and that’s the monthly amount to put on Schedule I – Income.  Then take a breath, quiet yourself down, and think about where it is likely to go. Put your best-effort estimated amounts in the best-effort expected expense categories. Might your car need a transmission or engine seals or tires or any one of those many things that go wrong with older cars?  (This is a 3-5 year Chapter 13 duration, after all.) How old is your furnace, or water heater, or roof, or exterior paint? Things always go wrong, even if we cannot predict the particular thing that will break down or when.

I’ve attached a transcript of rulings a judge made at the end of a trial I argued.  The judge approved this debtor’s practice of using Uncle Sam’s tax refunds as an emergency savings account.  It works.

I used to point out to my clients that a refund meant they lost the savings account interest that this money could earn.  I never succeeded in changing anyone’s mind,because when income is tight we need to force ourselves into saving the money for future needs.  That is the important lesson here.  It is not, it never was, that the tax refunds were put away for long term savings.  That money is needed for the big ticket repair items that otherwise is never affordable.  My clients were smarter than me.

 I’m Jed Berliner, a consumer protection and bankruptcy lawyer practicing in Central and Western Massachusetts.