With the beginning of tax season a mere four months away, now is the best time to start planning if you are a consumer considering filing for Chapters 7 or 13 Bankruptcy protection.  The connection between your taxes and bankruptcy is not immediately apparent, nor is the correct action to take to protect the most of your personal assets in a bankruptcy proceeding (especially in a Chapter 7).  However, when you consider that approximately 85% of people filing bankruptcy are entitled to a tax refund, the connection begins to become clearer.

Your tax returns and potential bankruptcy filing are invariably connected.  Your tax returns from previous years are used as evidence of your adjusted gross income and are provided to the trustee in bankruptcy before your meeting of creditors.  Taxes deducted from your paycheck are not counted as income for purpose of the Schedule I income calculation; this is important in a Chapter 7 where your monthly expenses must exceed your income and in a Chapter 13 where Schedule I might be used in calculating your plan payment.

Any tax refund you might receive affects and is affected by your bankruptcy as well.  In a Chapter 7, your refund is property of the estate and is subject to seizure if it is received within 90 days before filing or up to 180 days after discharge.  If it is not received in that period, the policy here in the Eastern District of Michigan is that it still has to be prorated and exempted.  The problem is that if you have to exempt a large tax return using the “wildcard” exemption, your attorney may be unable to exempt other assets as well.  Even more concerning is the case of the debtor that has equity to exempt; the “wildcard” exemption may not even be available to that debtor and the trustee will take the tax return.  In a Chapter 7, if you can plan a little ahead, you can prevent this money from being used to repay your creditors:

1. If you have no home equity to exempt, and little in the way of other assets, don’t worry, your tax refund will probably be exempt.
2. If you have home equity, or a large number of other assets that are not exempt under another category, you may need to preserve your “wildcard.”  If your Schedule I (income) is not in danger of exceeding your Schedule J (expenses) all you need to do is fill out a new W-4 and increase the number of exemptions you are taking.  While you won’t get a large check come tax time, you will notice an increase in your take-home pay.

Your tax refund amount matters less if you do not qualify for a Chapter 7 and file Chapter 13 instead because that money will likely end up with the trustee, for the benefit of creditors, no matter what.  The reason behind this is that if you decrease your monthly taxes, your Disposable Monthly Income (“DMI”), and thus your plan payment will most likely go up.  If you choose to leave it alone and receive a refund, you’ve most likely got to turn it over to the trustee anyway.

While the content of this article are legal in nature, and the author is an attorney licensed to practice in Michigan, this is opinion only.  You should consult with your own attorney before acting on any advice or, call us today at (248) 595-8617 for a free consultation.