Waiting for Your Tax Refund Before Filing for Bankruptcy? Big Mistake!

tax imageI just got off the phone with a potential bankruptcy client. We spoke for some length of time, during which she asked all the right questions regarding her own specific situation: can I keep my house and my car if I file, what are the costs associated with filing for bankruptcy, will mine and my husband’s income prohibit us from filing, etc. Normally, clients are not so prepared when they call, so it was refreshing for her to have thought things through enough to know what questions she wanted to ask. Just as she was getting ready to hang up with me, she stated “I’ll call you back and set up an appointment once I get my tax money back.”

Uh, oh.   Clients continue to make this same mistake every year, as the bankruptcy filings always seem to pick up between February and April. While tax refunds are not always an issue in every bankruptcy case (not all clients even receive a tax refund, much less a substantial one), there are an increasing number of Debtors that do receive refunds every year. And the ones who receive the largest refunds at tax time always are the ones who make the least amount of money throughout the rest of the year and cannot afford to lose these refund monies in their bankruptcy. These are the Debtors who rely on the Earned Income and Additional Child Tax Credits – refundable credits that can skyrocket the average tax refund for these particular Debtors to between $3,000.00 – $8,000.00.

Wait, you may say… aren’t the Earned Income Tax Credit (EITC) and Additional Child Tax Credits (ACTC) exempt? Yes, these particular credits are considered to be a “public benefit” and like welfare benefits, the portions of refunds attributable to these credits is exempt from attachment. But there is a catch: they are only exempt until such time as they are received – in other words, they are exempt only as a contingent interest. Once they have been received by the Debtor(s), the refund monies are then simply considered liquid – i.e “cash” – and can no longer be exempted under the “public benefits” exemption.

Now, all is not lost if a Debtor did not adhere to this advice, and received a tax refund prior to filing their bankruptcy case. In addition to the public benefits exemption, all Debtors are permitted a $4,000.00 “wild card” exemption to cover their personal property, which can include tax refunds (a married couple filing jointly has an $8,000.00 wild card exemption). However, what most Debtors do not realize is that their “wild card” exemption has to cover all of their other assets including: cash, bank account balances, household goods and home furnishings, jewelry, collectibles, sporting goods, guns, sometimes values of vehicles over the $2,400 regular exemption for 1 vehicle per Debtor, and/or additional vehicles, motorcycles, trailers, or boats. As you can see, the wild card exemption is typically used up by the Debtor in protecting their other assets from seizure by the bankruptcy Trustee, so there is often little left to be able to cover tax refunds. Any refunds that cannot be covered by an exemption will most likely be required to be turned over to the Trustee for distribution to creditors.

To see how this works in real life, let’s take this scenario: You complete your taxes for this year, and you are supposed to receive a $5,000.00 tax refund, consisting of an EITC of $3,000.00 and an ACTC of $1,000.00. If you file your bankruptcy before you receive your refund from the IRS, then we can exempt $4,000.00 of your $5,000.00 refund under the “public benefits” exemption, and will only have to attempt to fit the remaining $1,000.00 of the refund under the “wild card” exemption. If you wait to file until after you have already received your tax refund for this year, then we will not be able to claim anything under the “public benefit” exemption, and will have to fit whatever amount we can under the “wild card” exemption after taking into account your other assets. As the wild card exemption is only $4,000.00 to begin with, this will leave a substantial portion of your refund subject to turnover to the Trustee. As many clients do not have a lot of discretionary income to be able to pay the fees required to file bankruptcy, and many look to their annual tax refunds to be able to fund this endeavor, which Is equivalent to a double-edged sword.

What if you spent the money before you filed your case, you may ask? The Trustee will most likely ask to see documentation as to where the money was spent, and on what. The Trustee has powers to avoid transfers, and undo prior transactions, so that she can retrieve the money back for the benefit of your creditors. Also, the Trustee could simply make you pay the estate back the non-exempt funds before you will be able to get your bankruptcy discharge. This is why it is so important, if you can manage it at all, to file your bankruptcy BEFORE you receive your tax refund. As always, if you have a specific question regarding your particular situation call Manuel & Associates at 217-344-3400, and we will be happy to discuss it with you. We want to help you make the right decisions regarding your options, before you make that big mistake!

www.manuelassociates.com  or Call Us : 217-344-3400

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