Considering tax refunds when filing for bankruptcy

Many factors go into the decision as to whether to file for bankruptcy, but also when to file for bankruptcy. This post will discuss timing and other considerations as they relate to the receipt and spending of tax refunds.

During the early months of any year, most factors go into the decision as to whether to file for bankruptcy, but also when to file for bankruptcy. This post will discuss timing and other considerations as they relate to the receipt and spending of tax refunds.state people anticipate receiving a tax refund after filing their state and federal returns. It is important to remember that in Oregon, a bankruptcy trustee is generally entitled to take your tax refunds if you have not received and spent them prior to filing your bankruptcy petition. Oregon law, however, protects your federal refund to the extent attributable to earned income credit. Note that refunds due to state earned income credit and the federal additional child tax credit are not protected under that law. Laws applying to Washington residents are usually more generous, and it is quite rare that a Washington resident would lose a tax refund if not received and spent before filing for bankruptcy. Unfortunately, your ability to “exempt” property to keep it from the trustee varies from state to state.

Sometimes, the financial pressures that you face (a wage garnishment, for example) require you to file for bankruptcy before you receive and spend your tax refunds. In some circumstances, such as if you owe student loans, child support, or other non-dischargeable debt, the trustee seizing your refunds can even be a good thing. The money that the trustee receives will be used to pay down some portion of those debts. You would have had to pay those debts anyway.

It is preferable, though, to delay your bankruptcy filing until after you have received and spent your refunds. It is perfectly acceptable and legal to do so. I always advise clients in these circumstances to

(1) spend the money only on necessities (car or home repair, current medical treatment, clothing, home necessities, etc.),

(2) keep a written log as to what the money is spent on, and

(3) keep receipts for all purchases. While it is legitimate to spend the tax refunds in this way, the bankruptcy trustee is also entitled to ask you what you did with the money. If you do not have an adequate explanation, you can run into trouble with the trustee.

It is critical, however, that you do not use any of the money to repay debts to friends, relatives, or business associates. The Bankruptcy Code calls those persons “insiders”. Payments made to insiders within one year before filing for bankruptcy can be considered “preferences” or “preferential payments”. The trustee is entitled to recover preferences, and distribute the money equally among all of your creditors. This applies to both Oregon and Washington residents. For example, if you receive a $3,000 tax refund and then repay your mother the $3,000 that you owe her, and file for bankruptcy within one year after paying her, the bankruptcy trustee can pursue your mother to recover the money that you paid her. Keep in mind that if you owe relatives any money, you are free to repay them after your bankruptcy is filed.

Less critical, but still important, are unusual payments to a single creditor totaling more than $600 within the ninety days prior to filing for bankruptcy. Such payments can also be considered preferences which the trustee can recover. For example, if you owe your doctor $3,000, repay the debt with your tax refund, and then file for bankruptcy within the following ninety days, the trustee can recover those funds from the doctor. Among other things, this could jeopardize your doctor-patient relationship, and might also result in the doctor refusing to treat you any further.

This post is intended to be purely informational in nature, and cannot be considered legal advice.