Will the trustee get my income tax refund?
State exemptions for income tax refunds vary widely in bankruptcy cases.
An individual's income tax refund can be absorbed by the case trustee to pay back creditors in a bankruptcy action, although a number of exemptions exist to benefit the debtor.
In Chapter 13 cases, the refunds are considered property within the debtor's estate and are used as part of the repayment plan ordered by the U.S. Bankruptcy Court. But in Chapter 7 cases, in which all non-exempt assets are used to pay creditors, the tax refund also is at risk. In some cases, bankruptcy trustees may ask the Internal Revenue Service to send them the tax refund directly.
Bankruptcy attorneys may advise their clients to adjust the tax amount withheld from their wages in order to reduce the refund and to claim the maximum exemption available to them when they file their taxes.
"Bankruptcy trustees take income tax refunds more frequently than any other asset," according to attorney David Leibowitz, writing on BankruptcyLawNetwork.com. "You can protect your income tax refund by claiming it to be exempt. In most cases, you'll claim a [federal] "wild card" exemption. In some cases, you might be able to claim that an earned income credit or child-care credits are welfare benefits, which could be exempt under the law of your state."
State laws vary widely regarding tax refund exemptions. "Most people can exempt their tax refunds here in Massachusetts because we can choose the federal exemptions - and thus, the valuable wild card exemption," writes attorney Nicholas Ortiz for the website. "Note that if you must choose the Massachusetts exemptions instead of the federal exemptions because, say, you have substantial home equity, you will not be able to use the federal wild card exemption to protect a tax refund."
In Illinois, where Leibowitz practices, the state law allows debtors to exempt up to $4,000 of their income tax refund. In many states, the exemptions are sufficient to cover most, if not all, the amount that people expect to receive back from the government.
"Whether or not the Chapter 7 trustee will take an income tax refund usually depends on two things," explains Oklahoma attorney Dan Nunley on his website. "One, how large the refund is, and two, what percentage of your unsecured debts would be paid by the refund. If the total amount is small and the percentage paid back would be insignificant, the trustee is likely to abandon the tax refund and allow you to keep it."
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