I write about this every year because it is a recurring issue for people facing bankruptcy. Taxes have a bearing on bankruptcy whether you are owed a refund or whether you owe the IRS. Therefore, they must always be taken into account, but it is especially important during this first handful of months each year.
The first thing to remember is that if you are owed a refund at the time of filing, that refund is an asset of the estate and must be reported in Schedule B and hopefully exempted in Schedule C. If you owe taxes, they are reported on either Schedule F or E depending on whether they are priority debts or not. Your attorney can help sort that out. Tax debt and tax refunds arise on December 31st each year. So, if you file a bankruptcy on January 1st, then you must account for the tax situation that arose from just the day before. So, even if you do not file your tax return until April 15th (or October if you file an extension) you either owe taxes for the year that just ended or you are getting a refund (rare indeed is the person who lands right at zero, but I suppose it happens).
If you owe taxes for the preceding year, they will be considered a “priority” debt and a debt that cannot be discharged. In a Chapter 7, the IRS and any state agency you owe taxes to will begin collection activity after your Chapter 7 is closed. In a Chapter 13, you will have to make sure you pay enough into the plan for those taxes to be paid in full over the life of the Chapter 13 along with 4% interest for federal income taxes and 5% interest on Kentucky income taxes.
If you are owed a refund, you need to report the refund as accurately as possible in your schedules of assets. This means you will likely have to run at least a rough draft of your tax return to get a good faith estimate of what is due back to you. Then, you will attempt to cover the entire amount in “wild card” exemptions. If you cannot exempt the entire amount, you will need to make a determination with help from your attorney as to whether you should wait until you receive the refund or press on.
If you decide to wait until you receive the refund, then the smart thing to do would be to pay for the bankruptcy and spend the money on necessities, such as food or needed repairs to you car. Do NOT use it to pay unsecured debt, especially not to relatives. Your attorney can help you know how much you can hold onto and exempt.
Your attorney can also help you determine if older income tax debts, such as those that arose a few years prior to the bankruptcy, will be discharged in your Chapter 7 or 13. All of this is acceptable pre-petition planning to make the most of the fresh start bankruptcy allows.
In a Chapter 13, the debtor puts together a budget they present to the court. This budget encompasses Schedule I (income) and Schedule J (expenses). In order to get a Chapter 13 plan confirmed, it has to be feasible. Part of showing that a plan is feasible involves demonstrating that the debtor can actually make the payments proposed by the plan. If the money left over (the disposable income) when expenses are subtracted from income is substantially less than the proposed plan payment, then the plan is not feasible.
Sometimes the plan calls for payments that are just a bit of a stretch for debtors. This happens when the debtor is using the Chapter 13 to pay off arrears on a house facing foreclosure or when there is priority, non-discharged income tax debts that have to be paid in full during the plan. In these instances, the debtor and their attorney will likely engage in “belt-tightening” by shaving off amounts from expense items that they believe they can realistically accomplish.
However, there is a source of disposable income that may be lying hidden in all the paperwork. Many people over-withhold on their taxes. Some do this to avoid owing a tax debt at the end of the year and others like to have a self-created bonus. This latter practice is essentially loaning the United States government money for several months at zero percent interest. So, while it is a nice little psychological trick to force one to save money up, it is definitely not maximizing use of one’s resources.
Worst of all, if you have engaged in the belt-tightening on your budget as I mention above then you have created a set-point in the eyes of a trustee. They assume that is your actual budget. So, when they see tax refunds exceeding $1,200.00 per year (state and federal combined), then you belt-tightening budget may backfire.
Let me unpack that a little. In my hypothetical scenario, the debtor gets back an average of $3,600.00 per year in tax refunds. That comes to $2,400.00 more than the threshold that many trustees look too for reasonable withholding levels. This is $200.00 per month. The trustee would argue, and rightly so, that if the debtor used the proper withholding levels, they would have $200.00 more in pocket each month.
Now, in order to achieve the $200.00 plan payment needed to pay off the arrears on the house during the five-year bankruptcy, the debtor “shaved” expenses down by $200.00 each month less than actual expenses. This makes the budget really tight and barely sustainable, but the debtor thinks they can manage it. However, at the meeting of creditors, the trustee challenges the tax refunds and insists on a $400.00 per month plan payment reflecting what the debtor proposed plus the $200.00 per month that has been withheld in excess of taxes actually owed.
A quandary develops. The only way to preserve the $200.00 plan payment is to go back and amend Schedule J to show actual expenses. Ah, but that set-point I mentioned is already established. Now, the debtor will have to produce documentation to support higher expenses than they originally claimed (under oath I might add). Most people do not keep records accurate enough to document all their expenses.
So, if your attorney suggests that you plan to change your withholding on taxes so that less is taken out of your paycheck, trust them. This will allow you to set expenses at reasonable, sustainable levels from the very beginning and yet meet the needs of the plan. Honestly, $200.00 more in hand each month is exactly the same as $2,400.00 once a year. Actually, it is more because when you let that money build up with the Internal Revenue Service, you are losing a tiny bit of the “time value” of those dollars.
My last post hit some highlights on tax debt from a presentation by Professor Williams at the 16th Biennial Judge Joe Lee Bankruptcy Institute. This post delves a bit deeper into a specific tax law I touched on in that last post. The tax code provision is 26 USC Sect 1398 and it applies specifically to Chapter 7 and Chapter 11 bankruptcy cases. It does not address Chapter 13 cases.
The main thrust of Sect. 1398 is to allow for a Debtor to make an election to treat their ordinary tax year as two separate, shorter tax years. The first tax year would go up to and include the day before a Chapter 7 or Chapter 11 is filed. The second tax year includes the filing date of the bankruptcy and runs through the remainder of the normal tax year. This does NOT happen automatically, so the Debtor must take affirmative action.
If a married couple file jointly, the Joint-Debtor may also make this same election, but again it has to be an affirmative step taken by the Joint-Debtor; the Debtor’s election does not automatically apply to the Joint-Debtor. The election of the Debtor and election of the Joint-Debtor must be made no later than the due date for filing the return for the first short year and it cannot be undone once made.
By making the election, income that is part of the bankruptcy estate is taxable to the estate instead of to the Debtor. An example of how this might matter for a consumer debtor is if the Debtor becomes entitled to an inheritance or lottery winnings during the 180 days after filing. These monies get pulled back into the estate and might not be exempt or only partially exempt. Without this election, the Debtor may be hit with taxes on monies they were not able to keep.
This tax code provision would most usually come into play for business related bankruptcy debtors. Even if the Debtor is an individual, they own a business entity that may not be exempt or only partially exempt. The revenue that business generates would be income to the estate to the extent that business entity is not exempt. This can occur through ongoing revenues of the business or liquidation. The Debtor, again, would not want to be liable for taxes on funds they cannot enjoy.
The 1398 provision does not, however, have any impact on tax debt arising prior to the filing of the bankruptcy and the vast majority of consumer debtors will never need to avail themselves of this election to split tax years. Business related debtors need to be mindful of this option when there are non-exempt assets. Businesses entering bankruptcy as an entity, rather than the individual owner, must remember this election.
Yes, you can. The question in filing a bankruptcy when you have recently moved to a new state is which state’s law determines the exemptions you use. There is a really odd rule for determining this found in 11 USC Section 522(b)(3)(A). Since we are looking at a recent move, then the 730 day period would not apply. If, though, you have lived in the state where you are currently at for 730 days, then you will use the laws of that state to determine exemptions. For everyone else, you must go back to the time before that 730 window (2 years) and look at those preceding 180 days (6 months). Okay, I know – I just lost you.
If you have recently moved, take the day you want to file your bankruptcy and go back in time 730 days. Then, go back in time another 180 days before that for a total of 910 days. The period of time between 910 days and 730 days is what you want to look at. Once you have this time frame mapped out on a calendar, you then have to determine what state you actually lived in for most of that time. That is going to be the state whose law you need to look at to determine exemptions.
Now you have to go to the statutes of that state and find their exemption laws. As you look at these statutes, you are going to want to figure out whether those laws have a residency requirement or a domiciliary requirement. A domiciliary requirement means you actually live in that state. A residency requirement means you have a place there where you could live even if you do not currently park your fanny there. There are other factors also, such as whether you can vote in that state or not that can affect residency status, but those technicalities go beyond the scope of this post.
If there is a domiciliary or residency requirement to use that state’s exemptions, then even if you do not qualify to use your current state of domicile’s exemptions, you will use the federal exemptions by default. This issue can have a dramatic impact on your bankruptcy case, so it is worth spending a little in order to be sure your assets are properly exempted.
Despite my reassurances, debtors always have anxiety about the meeting of creditors. When the 5 to 10 minutes that the meeting takes have passed, they are invariably relieved. Bu, then the trustee often says something that perplexes them. He or she says, “I am going to abandon the estate’s interest in…”.
Abandonment sounds like a bad thing and usually it is. But, in bankruptcy it is a good thing. When the bankruptcy is filed, all the property of the debtor goes into an estate. The trustee has control over that estate. He or she can liquidate non-exempt assets of the estate; sell them and distribute the cash to creditors. For nearly all of my clients, all assets are exempted under the more generous Federal exemptions. When this is the case, then the trustee has nothing they can liquidate which would realize money for the creditors.
For any asset that is fully exempt or of no value to the estate, then the trustee will abandon that asset. That means he or she relinquished the ability to control or sell the property. So, in bankruptcy abandonment is a good thing.
A decision in the Bankruptcy Court for the Eastern District of Kentucky highlights a mistake made too often in Chapter 7s where the debtor lives in a mobile home. In Kentucky, mobile homes are not terribly mobile and often remain in place for decades. So, the name “mobile home” is a bit misleading. The legal term for mobile homes is “manufactured home” which also seems silly because all homes are manufactured in one way or another. Anyway, mobile homes get physically fixed to the land and people stop thinking of them as titled property such as cars, boats, trucks and trailers. However, they are titled. Even though physically fixed to the land, they may not be legally affixed to the land.
Now, when one files a Chapter 7, everything they own and everything they owe goes into an estate. They pull things back out by using exemptions and reaffirming secured debts. Often debtors keep their homes because they have enough exemption to cover the equity in their home and are able to pay the secured debt payments (the mortgage) when all their other debts are discharged. Each person can claim almost $23,000 in homestead exemption using the Federal exemptions. So, if you own a home worth $120,000 and you owe $100,000 secured on the house, then you can use the exemption and keep the house by reaffirming the $100,000 secured debt with the remainder exempted.
Here is where the problem comes in for mobile homes. The only way a loan is secured against a mobile home is on the title as described in KRS 186A.190. Actually, there is one other way, but it involves surrendering the title and filing stuff with the county clerk and effectively converting the mobile home into a house from a legal standpoint. Anyway, most people do not do that. So, if there is a defect with the security interest on the title, then the loan is not perfected and cannot be reaffirmed. That may leave a very HIGH amount of equity in the mobile home requiring exemption.
If the mobile home is also on land that you own, then you have the challenge of applying the homestead exemption to your land and then also hoping you have sufficient exemption to cover the value of the mobile home. If the title has not been surrendered and the mobile home affixed to the land legally, then you must exempt two separate assets: the land and the manufactured home. If the home has been affixed, you are in far better shape because it is one asset, but you still must make sure the loan is properly secured.
Like in In re Owens, 09-62087 (Bankr.E.D.Ky., 2010), if the title is defective in regards to the security interest, then you could lose your home. In other words, if there is a problem with the title then you may have no secured loan to reaffirm and not enough exemption to cover the difference. Then, the trustee will keep the mobile home, sell it (if you can’t come up with money to redeem it), and distribute the proceeds to all unsecured creditors. If you live in a mobile home, be sure that your bankruptcy attorney examines the title and makes sure that any security interest is properly in place.
The bottom line is that if your home is a manufactured home and you are looking at bankruptcy, make sure your attorney does a thorough check as to the title, security interest, and exemption issues.
It may seem impossible to pay the taxes owed and when faced with that impossibility, some people decide to not file their tax returns at all. I am not talking about filing an extension – I mean ignoring the whole issue. While there may be reasons to do this that are legitimate (though I cannot think of one) I am not a lawyer who is an expert in tax law or criminal law related to taxes. So, what I am writing is from a bankruptcy standpoint.
When looking at taxes from a bankruptcy standpoint, the best advice is to file your returns timely whether or not you can make payment at that time. Timely filing of your tax debt starts the running of certain time frames that can allow that tax debt to be discharged at a subsequent date. Failing to file would prevent that tax debt from being discharged.
If you have filed a bankruptcy during this current calendar year, then the filing of the return is essential to your bankruptcy moving forward. Most Chapter 7 trustees will insist on seeing the prior years return before they will “abandon” their interest in the estate in case there is a refund coming back in excess of exemptions. Chapter 13 trustees will insist on it because it is required by law and to see if you are withholding too much in taxes instead of paying enough into the Chapter 13 plan.
Finally, the return being filed only defines the exact amount refunded or owed. On 12/31 of last year, you either owed a tax debt or had a refund owed to you. Subsequently filing a bankruptcy does not change either of those circumstances. So, you might as well file the return to give definition to where you are at. If you are in a Chapter 13 and owe taxes from last year, they will be filed as a claim in the Chapter 13 and paid through the plan so you should NOT make payment with your return.
A couple of days ago I talked about the tax refund issue that is involved in both a Chapter 7 or a Chapter 13 bankruptcy. Today I will talk about the issue that arises only in a Chapter 7 (sort of). To qualify for a Chapter 7, your household income must be lower that the median income for your family size in the area where you live. This information can be found at the Trustee’s website on means testing. If your gross income is too high, you can go through a second time and deduct certain expenses. These include taxes taken from your paycheck.
If you pass the means test on the second round, the U.S. Trustee still can look at your income and expenses and see if you could actually pay a significant amount into a Chapter 13 plan. If you actually have over $160 in disposable income despite passing the means test, then the trustee may object and move to kick you out of the Chapter 7 (either as a dismissal or conversion to a Chapter 13).
Part of the trustee’s analysis is looking at your tax refund. If you received a substantial refund (I heard one trustee say $1,200.00 was the range they began looking), then they may demand that the excess taxes paid be attributed to your income. So, if you receive a $6,000.00 refund, you arguably could have $500.00 more per month to pay creditors. In practice, I have not seen this kind of challenge happen often, but it is a potential issue.
There are two issues regarding tax returns in a Chapter 7 and two in a Chapter 13 that need to be commented on. Today I will simply do a short post on the one issue that overlaps in both. When one files bankruptcy, whether a Chapter 7 or a Chapter 13, all assets must be listed. A tax refund that is due to you is an asset that arose on 12/31 of the year preceding the filing date. If you are filing now, the tax refund (if you have one coming to you) arose on 12/31/2012. Even if you do not know the amount due back to you, the right to receive it still existed on that date so you need to give a best estimate of those refunds on Schedule B.
Once you have listed your tax refunds (state and federal), you need to try to exempt them on Schedule C. Hopefully you will have enough exemptions to cover the full amount. If so, then you can keep them. Look back at some of my prior posts regarding exemptions to help with this part. You need to wait, though, until after the meeting of creditors to spend the tax refund because the trustee might have some basis for objecting, though if you calculated it correctly, this is very unlikely.
If you cannot cover the entire refund with exemptions, then you will likely have to surrender the excess to the trustee in a Chapter 7. In a Chapter 13, you will have to pay the amount you could not exempt to the unsecured creditors over the life of the plan.
Check back in a few days from now to take a look at the other issues regarding tax refunds in Chapter 7 and Chapter 13 bankruptcies.
The new year also ushers in tax season. Instead of sugar plums we have receipts of deductions dancing in our heads. This season creates some additional concerns pertaining to bankruptcy. If you are trying to file a Chapter 7 and you just squeak in under the means test, pay special attention to your deductions. If you have claimed too few tax deductions on your W-4, then the trustee might object that it is an abuse for you to get Chapter 7 protection (overcome the presumption from the means test). Another related issue is the size of your tax refund. If you have claimed too few deductions then you will likely have a refund coming to you.
Even if you pass the means test regardless of under-deducting, you still need to be mindful of your refund. If you receive your refund prior to filing your petition, it would be wise to spend in on household necessities like groceries or repairs that are long past due, but which will not substantially increase the value of your home or automobile. If you will not receive the refund until after filing, be sure to ask your attorney to see if there is a “wild card” exemption available that can cover it. Otherwise, you may have to surrender some or all of your refund to the trustee.
In general, it is not good to claim too few deductions. Sure, you and most people enjoy having the refund once a year, but you are essentially making an interest free loan to the government when you under-deduct. Along with that issue, add the concern about the means test and possibly losing your refund in a Chapter 7 and it is just wiser to claim the actual number of deductions available to you.
- What your bank CAN and CANNOT do when you file bankruptcy
- Tax Time!
- Interest Rates on Secured Claims in Chapter 13 Cases in the EDKY
- CAUTION: Tax Refund
- When Business Owners Should File Bankruptcy
- To File or Not to File: Attorney decision making
- Deadlines for Filing Prepetition Tax Returns in Chapter 13 Cases
- Delinquent Property Tax Claims in Chapter 13 Cases
- Lessons Learned the Hard Way
- Miscellaneous Hot Topics in the EDKY
- ‘Tis the Season
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