Bankruptcy and Income Tax Refunds
Tax refunds are generally considered to be assets and can be taken by the bankruptcy trustee and distributed to your creditors. However, in many States it is possible to exempt all or a portion of the refund and protect it from your creditors. The Earned Income Credit portion of your refund can also be completely exempted in some States.
Another strategy often to protect your income tax refund is to “spend-down” your refund on necessities prior to the filing of the bankruptcy. Since the money is spent, it is no longer considered an asset, and the purchase of necessities generally does not create any new assets. But be careful, some states take a pro-rated portion of your income tax refund as a matter of practice and you’d find yourself owing the trustee even if you spent down your refund on necessities.
In Chapter 13 bankruptcies, some jurisdictions require that you turn over a portion of your income tax refund each year. In other jurisdictions, you are allowed to keep your income tax refund each year.
As you can see, the laws in each state do vary significantly in this area of bankruptcy law, so be sure to consult with a bankruptcy attorney familiar with the local laws before receiving your refund. Bankruptcy Laws in Your State
Many bankruptcy attorneys often see a large rush in filings during the 1st Quarter, when people receive their tax refunds and are able to pay their bankruptcy attorneys to get their cases filed. This is a legitimate way to spend-down the refund and a good way to pay for a bankruptcy filing. I expect that the anticipated economic aid package that will give most working Americans between $600 and $1200 will also cause a boost in bankruptcy filings.