The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 re-emphasized the need for a Chapter 13 debtor to commit all of his or her disposable income to repaying creditors during bankruptcy. Since that time, Chapter 13 bankruptcy trustees across the country have argued that tax refunds constitute disposable income – income not needed by the debtor to pay reasonable and necessary expenses, such as food, transportation and shelter. Courts have unanimously agreed with the trustees: tax refund money is surplus, and the Chapter 13 debtor must turn over these refunds to the bankruptcy estate.
There are a few ways to combat this loss during a Chapter 13 bankruptcy. The most obvious way is to not create a tax refund in the first place. This means careful vigilance of your tax situation. Instead of Uncle Sam holding onto your money throughout the year, make sure that you only give the tax man what is owed – and no more.
Another way to avoid an income tax loss is to include language in the bankruptcy plan that excludes income tax refunds. This exclusion must be supported by evidence of the need to pay a reasonable and necessary expense. For instance, you may propose to pay annual property taxes with income tax refunds. These types of proposals have a low success rate and will almost always draw an objection from the trustee or a creditor. Furthermore, the bankruptcy court may be reluctant to allow this proposal due to the unpredictable nature of using a tax refund as income (the refund may be what you expect, it may be more, it may be less, or it may not come at all).
Finally, many Chapter 13 debtors attempt to modify their plans to excuse a particular refund, or part of a refund. Some courts and trustees will allow a debtor to keep money from an income tax refund when the debtor shows that the money is needed to pay reasonable and necessary expenses. For instance, if the debtor suffers an unexpected expense, such as an unexpected medical bill, funeral expenses, or a car repair, the debtor may be able to keep tax money to cover the expense. The bankruptcy court will not allow the debtor to keep tax money to pay for food, utilities, a car payment, or other expenses that should be paid by the debtor’s regular income.
Income tax refunds (and underpayment of taxes) during Chapter 13 bankruptcy always cause headaches, so the best advice is to pay attention to your income. A regular visit to a seasoned CPA will avoid tax issues and keep more money in your pocket.
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