Who Owns and who gets to keep the Tax Refunds in a Chapter 7 or Chapter 13 Bankruptcy?

Well, tax season is finally over or at least winding down.  Most of my clients have already received their 2013 state and federal income tax refunds.  The Minnesota property tax refund and Minnesota rent credit refund won’t be sent, however, until later in the year.   Who owns the tax refunds is always a big issue in any kind of personal bankruptcy, whether it’s Chapter 7 or Chapter 13.  This is because refunds not yet received are considered an asset, even the tax refunds for this year that won’t be received until next year.  Most people don’t ordinarily think of these as assets, because they may be way out of reach at least for now.  But the Chapter 7 and the Chapter 13 bankruptcy trustees definitely count them as assets.

In a Chapter 7 bankruptcy the starting point in answering the above question is that the bankruptcy  trustee owns the refunds. This can be said because upon the filing of a Chapter 7 bankruptcy, ownership of everything – all the Debtor’s assets right down to his or her socks – is transferred to the trustee.  My job as a lawyer representing the Debtor is to keep the trustee from being able to keep as much of the assets as possible by claiming those assets as exempt.  Anything that’s exempt can’t be kept by the trustee.  When you see the term “no assets case,” that means it’s a case where all of the assets were exempt so that the trustee was not able to keep anything.  Most of the Chapter 7 cases I file fall into this category.  The ownership only passes to the trustee in theory, and then it comes right back to my client.  A relatively painless process.

In a Chapter 13 bankruptcy there is no passage of ownership to the trustee, but the trustee takes the assets into account when determining what the payments are to be in the Chapter 13 Plan.  If there are any non-exempt assets, the payment plan must provide enough so that the unsecured creditors receive an amount equal to at least the amount of the non-exempt assets.  This is referred to as the “best interests of the creditors rule.” When we know there are going to be non-exempt assets, sometimes a Chapter 13 can be preferable.  This is because it is usually easier to keep an asset and make some monthly payments than it is to give up the entire asset.

When it comes to tax refunds as you can see, the key to happiness in a Chapter 7 or Chapter 13 bankruptcy is to be able to claim them as exempt.  This can often be easier said than done.  First of all, if you are claiming the Minnesota State exemptions, there is no exemption for tax refunds.  There just was a case where the Debtor was claiming that the property tax refund was “relief based on need” and therefore exempt under the Minnesota state exemptions, but the court said no; so there remains no exemption under the Minnesota state exemptions for any kind of tax refunds, at least not that I know of.

Luckily most of my clients qualify to use the Federal exemptions.  Under the federal exemptions, each Debtor has what we call a wild card exemption under which up to $12,725 of anything can be claimed as exempt.  When the parties are married and filing a joint case, each of them has a wild card  (also called the catch all) exemption of up to $12,725.  It is often said that a married couple claiming the federal exemptions gets to double their wild card.  This is absolutely not true, and you really have to be careful about that kind of thinking.

When a married couple file a joint Chapter 7 or 13 case and claim the federal exemptions, the Debtor has a wild card exemption and the Co-Debtor has a wild card exemption – but that exemption  does not double.  I often find myself pulling out a note pad and making a “his” and “her” column to try to keep track of this.  Assets owned by “him” and claimed as exempt under the wild card go in one column and assets owned by “her” and claimed as exempt under the wild card go in the other.  Joint assets can be equally divided between the columns.  Neither column can total over $12,725.  And beware:  a lot of stuff you may think of as joint may be looked upon differently by the trustee.

When the assets include tax refunds, the question arises as to which of the two columns the tax refunds belong in.  Years ago I assumed that if the tax return was joint, then the refund should be split evenly between the spouses for purposes of claiming it as exempt.  Turns out this is not how the 8th Circuit Bankruptcy Appeals Panel sees it.  In the case of In re Carlson decided in 2008, they decided that the tax refunds have to be prorated between the spouses based on the each spouse’s income.  So if one spouse earned 80% of the income, then 80% of the refunds gets attributable to that spouse.    If one of the spouses is not working, then all the refunds belong to the spouse who works.  This can obviously be a problem if allocating it that way runs one spouse’s wild card exemption  above the magic $12,725 level.

It’s complicated.  Not properly claiming the exemptions for the tax refunds is one of the most common mistakes made by people who file their own case without a lawyer.  Most of the time I can manage to claim all of the tax refunds as exempt so my clients can keep them, but sometimes I just can’t get it all.  For one thing, there are always other assets in addition to the refunds for which the wild card exemption is needed.

This post  is for general information purposes only and does not create an attorney-client relationship.  It is not legal advice. Please consult the attorney of your choice concerning the details of your case.

 

 

A few tips about Tax Refunds in Chapter 13 Plans

It’s tax time – again.  For many, including myself, it can be a time of fear and loathing.  Given a choice between having a colonoscopy or going to see my accountant to prepare my annual taxes, I would probably choose the former.  I’m relieved to be able to say that mine are done and filed.  So glad to have that over with.  Since I’m self employed, I almost always have to pay in.

For my Chapter 13 clients tax time has another layer of complexity, trickiness might be a better word.  Most Chapter 13 plans in Minnesota are required to have a provision that says the Debtors are to provide copies of all annual state and federal income tax returns to the Trustee’s office as soon as the returns are filed.  If they are to receive a refund, the provision usually allows married debtors filing jointly to keep the first $2,000 of the refunds, and allows individual filers to keep the first $1,200 of the refunds.  After those allowances, the balance of the refunds is to be paid into the Chapter 13 Plan as an additional contribution.  This contribution benefits the creditors, but usually has no particular effect on the monthly payment plan for the Debtors.  After making this extra contribution, in most cases the monthly payments under the Plan continue unchanged and on the same schedule.

The preferred method of sending the tax returns to the Trustee is now to make the return into a PDF and email it to an email address that the Trustee’s office has designated for that purpose.  After that the Debtors should wait for a letter from the Trustee’s office which will tell them how much of the refund should be mailed in.  The letter is usually sent promptly, although it comes by snail mail.  Since I tend to be copied with both the emails and the snail mail, I have had quite of bit of this correspondence arriving on my desk over the past few days.  So far this year there has been only one case where I disagreed with the way the Trustee’s office was calculating how much my clients were to send in.  When that happens, I have always been able to straighten things out with a of series of email exchanges with the staff person who did the calculations.

Here’s a few important things to know about how they calculate exactly how much the extra contribution from the tax refunds is supposed to be.  First of all, if you get a refund from one level of government – for example the feds – and have to pay in to the other level of government – for example the state, usually you can expect the amount you had to pay in to be deducted from the amount of the refund.  If you paid to have an accountant or other preparer to do your returns, be sure to send the bill for the tax preparation in to the Trustee’s office along with the tax returns.  At least this year I have been seeing the Trustee’s office allow a credit for the cost of tax preparation.  In one letter that just arrived on my desk, they allowed a credit for a $96 processing fee from TurboTax.  

If you find your refund to be a whole lot more than the part you are allowed to keep, I’ve never seen anybody get in trouble for adjusting their wage withholding so that next time the refund won’t be so large.  Such adjustments can involve a lot of trial and error, however, and you might find it pretty hard to get it just right.  It’s easy to overshoot the goal and wind up having to pay in to the IRS and Department of Revenue.  Like Garrison Keillor says, be careful.

Keep in mind that everything I say here only applies to Minnesota cases.  I would expect that practices vary quite a bit around the country concerning this topic.  And as I always say, this post is for general information purposes only.  It is not legal advice and does not create an attorney-client relationship.  Please consult the attorney of your choice concerning the details of your case.

 

What NOT to do while going Over the Fiscal Cliff

 

Cliff near Pike's Peak

Watch out for the temptation to under withhold .

Most people I talk to have not heard of the “fiscal cliff.”  Those who have believe it will not affect them.  This includes a husband and wife I met with yesterday.  But when I ran the numbers for them, based on a November 1st article in Forbes, I found that between the two of them their paycheck withholding should go up by about $438 per month.  That is, the net take home pay for the two of them together will be $438 less per month starting January 2, 2012.  That is just a few days from now.  When I tried to warn them and suggested that they should be thinking about how they would deal with this, they blew me off.  They are absolutely in denial about the prospect that this could ever happen.  If we go over the fiscal cliff as scheduled,  this should come as a heck of a shock.

My calculations assume, of course, that no steps will be taken to reduce the impact of the fiscal cliff.

From where I sit it looks like a majority of people are living right on the edge.  For them a drop in take home pay like this will mean they no longer have the funds to pay their credit card debt.  Often when people are in such a situation, they go to their employer and increase the number of exemptions they are claiming for withholding purposes on their paychecks.  They claim more withholding exemptions than they should.  Some increase the number of exemptions to the point that no taxes are being withheld at all, and for them all that is withheld is social security and medicare.  This increases their take home pay, but it is at the cost of not having enough taken out to cover state and federal tax liability.  The income which should have been withheld for taxes is then used to make payments on credit card debt.  Often this is still not enough to get that credit card debt under control.

When it comes time to file their tax return, they find that they owe a tax debt which is too large for them to pay.   Now on top of the credit card debt there is a substantial tax debt.  Eventually they wind up in my office.  I can help get rid of the credit card debt.  But as long as the tax debt is less than three years old, there’s nothing I can do to help with the tax debt.

The worst creditors you can have are the IRS and the Minnesota Department of Revenue.  In almost all circumstances, it is better to stop paying other debts before you stop or reduce the withholding of taxes from your pay check.  Don’t fall for the temptation to unreasonably increase the exemptions you claim for withholding from your paycheck.  That will work for a short time, and then you’ll really wish you hadn’t done that.

This post is for general information purposes only and should not be considered legal advice.  You should consult the attorney of your choice concerning the details of our case.  Reading or responding to this post does not create an attorney-client relationship.  I am a debt relief agency helping people to file for relief under the federal bankruptcy code.

 

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