Each year during tax season, hundreds of people lose some or all of their tax refund in bankruptcy court. After the first of each year, here is a fairly typical discourse between the bankruptcy trustee and the person who filed the bankruptcy petition, also known as the debtor:
Trustee: Have you already filed your taxes for last year?
Debtor: Yes, I filed taxes a week ago.
Trustee: Will you be getting a refund?
Trustee: How much?
Trustee (nonchalantly): Based on your schedules, you can still exempt $1,000. The other $3,000
is not exempt. Write a check payable to me for the $3,000, or send your payment to
the address on this card. Any creditors present? No creditors are present. This
concludes the meeting. Good bye.
What has just happened? In essence, the debtor was told he had to pay $3,000 to creditors and the trustee to make sure that his bankruptcy case completed successfully.
Is this something the debtor expected? Probably not.
Did it have to happen? Probably not.
Let’s rewind. The bankruptcy trustee was asking the debtor if he was expecting a refund because the trustee wanted to figure out if the debtor had any additional money coming his way. This matters because when you file bankruptcy all of your property becomes property of the bankruptcy estate and can be distributed or sold to creditors unless you can exempt it. If you have already used up all available exemptions, then any new property or funds that you acquire during the case would be channeled to creditors. If you still have some exemptions left, then you may be able to exempt part of the extra funds, and would have to part with whatever is not exempt, just like in the example above.
If this debtor delayed filing taxes, for example by getting an extension until October, this would not have helped, because he is still entitled to claim the refund during his case. If someone has a right or an expectation of receiving any funds or property, it usually counts the same way in the bankruptcy case as if he already had the funds in his pocket. An easy illustration of this concept is a winning lottery ticket for $5,000 that has not been cashed yet. Although the debtor does not have the $5,000 yet, he has a definite right to receive $5,000, which is the same from the trustee’s point of view.
If the debtor had no idea how large his refund would be, the trustee would wait. And wait. And wait. It doesn’t help to delay the resolution of the question, because the longer the case stays open, the more issues can brew up. The trustees can wait a long time – in some extreme cases, more than 10 years – if there is an unresolved question as to how much the debtor is entitled to receive. If there are unfiled taxes, the trustee would expect them to be filed, and any non-exempt refunds to be given to the trustee before the case is completed.
If the debtor gets tired of waiting for the discharge of his debts and decides to walk out of the Chapter 7 case–well, he may not necessarily be able to do it. Although the debtor can ask the court to dismiss the case, the right to leave the case is not automatic or absolute. If the trustee thinks there could be some significant funds that could be distributed to her and the creditors, the trustee will likely oppose debtor’s request to close the case.
If the debtor is not in a Chapter 7, but is instead in a Chapter 13 bankruptcy with a payment plan, then any non-exempt funds received before the payment plan is confirmed might increase the amount of the monthly Chapter 13 payment.
Last but not the least, the debtor in our example probably could have easily avoided both the surprise and the loss of the funds. Unless there was some emergency that necessitated the rushed filing of the case, he should have filed all his taxes before filing bankruptcy, then received and spent the refund. If he had some legitimate expenses such as insurance, mortgage, medical treatments, groceries, or car maintenance that the refund could be used for, these expenses should have been paid before the case was filed.
The same holds true for any other uncertain asset or recovery. For example, if somebody defrauded you or injured you, and you have a right to file a claim or lawsuit against them, you may want to get that claim resolved before your bankruptcy case. Your local bankruptcy attorney should advise you on available bankruptcy exemptions that you can use.
Don’t put off the resolution of uncertainties, and you will minimize the risk of delays in your bankruptcy case, surprise requests by the trustee, and unnecessary loss of funds and property.