Many people look forward to tax season because they receive a large tax refund. However, what do you do if you are struggling with debts? Do you file your tax returns before or after filing for bankruptcy relief? Keep reading to find out three important things to know about filing taxes before filing bankruptcy.
Three Things to Know About Filing Taxes Before Filing Bankruptcy
Before filing a Chapter 7 bankruptcy case, you need to consider several things. One important factor is whether you anticipate receiving a tax refund. Tax refunds are one of the most common assets that Chapter 7 trustees seize in bankruptcy cases.
The primary role of the Chapter 7 trustee is to represent the best interest of the unsecured creditors. Examples of unsecured debts include:
- Personal loans without collateral
- Medical debts
- Credit cards
- Past rent and lease payments
- Most taxes owed to the government
- Student loans
- Unpaid domestic support payments
These creditors do not have collateral to secure their loans. Therefore, most of these debts are discharged through bankruptcy. However, taxes, student loans, child support, and alimony are not discharged. Therefore, you still owe these debts.
If the Chapter 7 trustee seizes assets, he uses those assets to pay your unsecured creditors. Therefore, before you file Chapter 7, consider these three things about tax refunds:
Filing Taxes Before Filing Bankruptcy: Your Tax Refund Is Part of the Bankruptcy Estate
Any assets that you own or have an interest in when you file your Chapter 7 bankruptcy petition are part of the bankruptcy estate. The Chapter 7 trustee can liquidate any asset in the bankruptcy estate to pay unsecured creditors. However, you can protect specific amounts of equity in particular assets.
Equity is the amount of money the asset is worth after deducting any liens against the property. For example, your tax refunds would be worth the amount you receive from the Internal Revenue Service and your state taxing authority. If your tax refunds total $6,000, the equity or value of the asset is $6,000.
However, bankruptcy exemptions may protect most or all of the tax refunds. Depending on the state law where you reside, you may use federal bankruptcy exemptions or state bankruptcy exemptions. The state bankruptcy exemptions vary by state. You can learn more about bankruptcy exemptions here.
Let’s assume you live in South Carolina. Under South Carolina state law, you must use South Carolina bankruptcy exemptions. The exemption for cash (the bankruptcy exemption you would use to protect anticipated tax refunds) is $5,900 per debtor. You also have a wildcard exemption you can use of $6,100.
Therefore, if your bank account balances and other liquid assets are minimal, your tax refunds would be protected by bankruptcy exemptions. That means the Chapter 7 trustee would not take your tax refunds even when filing taxes before filing bankruptcy.
IMPORTANT NOTE: Bankruptcy exemptions are updated according to state law. You must check for the current exemptions amounts for your state. If you can use the federal bankruptcy exemptions or the state bankruptcy exemptions, you need to compare the exemptions to determine which option is best in your situation.
Spending Your Tax Refunds Allows You to Keep the Money
You can avoid tax refunds from being an issue in your Chapter 7 case by spending the tax refunds before you file for bankruptcy relief. In other words, file your tax returns, receive your refunds, and spend down the refund money before filing the Chapter 7 petition.
However, you need to be careful how you spend the refund money. Generally, you should not have a problem spending the tax refund on ordinary household expenses. Examples of ordinary household expenses include:
- Rent or mortgage payments
- Clothing (except for luxury purchases)
- Medical and dental expense
- Car payments
- Repairs and maintenance for cars or homes
- Insurance payments
- Education expenses for you or your children
The goal is to have little to no tax refund money left when filing your Chapter 7 bankruptcy petition.
IMPORTANT NOTE: If you pay relatives or friends before filing bankruptcy, the Chapter 7 trustee could sue them to get the money back. Likewise, if you pay off a creditor, the trustee might sue the creditor to get the money back. So before paying any debts with your tax refunds, talk to a Chapter 7 bankruptcy lawyer.
What Happens If You Have Not Filed Tax Returns in Years?
A requirement for receiving a bankruptcy discharge is filing all required tax returns. If you were required to file tax returns but did not, the bankruptcy court dismisses your bankruptcy case. The Bankruptcy Code requires you to provide a copy of the most recently filed tax return no later than seven days before the date set for your First Meeting of Creditors (bankruptcy hearing).
If you are not required to file tax returns, you do not need to worry about this requirement. However, the Chapter 7 trustee may question you about why you are not required to file tax returns at your bankruptcy hearing.
Some individuals can file Chapter 7 without a lawyer. However, if you have not filed required tax returns, you may want to seek legal advice before filing a Chapter 7 bankruptcy case. You could have issues that are too complex to handle without the advice and guidance of an experienced bankruptcy lawyer.
What Happens to Tax Refunds in a Chapter 13 Bankruptcy Case?
There are several ways that tax refunds could impact a Chapter 13 bankruptcy case. First, because Chapter 13 bankruptcy cases involve a repayment plan, they are more complicated to file. Usually, it is best to seek advice from a Chapter 13 bankruptcy lawyer.
Large tax refunds could slightly increase your Chapter 13 payment, depending on your financial situation. However, in some cases, you may need to turn over your tax refunds each year during your Chapter 13 case if you do not want your monthly payments to increase. An attorney analyzes your situation and explains the best option for you.
Bottom Line – Wait to File Chapter 7 if You Anticipate a Large Tax Refund
If possible, wait until after receiving your tax refunds and spend down the amount before filing Chapter 7. If you cannot wait, talk with a Chapter 7 bankruptcy lawyer.
Ascend can help you locate a bankruptcy lawyer that offers free consultations. We can also provide guidance about getting out of debt without filing bankruptcy. Contact our office to speak with someone about debt-relief options and bankruptcy. Most of our services are free of charge.