Will I get to keep my tax refund?

The answer to this question, as with so many bankruptcy questions, comes down to timing. The set-off provision of the bankruptcy code, 11 U.S.C. 553, basically says that the bankruptcy code does NOT change the rights of the IRS (and certain other creditors/debts) to retain your tax refund. However, not only does the debt owed to the IRS need to already exist prior to the date your filed your bankruptcy petition, but your right to receive the refund had to arise before your filed the petition also.

This gets a little tricky because most people think their refund came about (or arose) when they filed their tax return. Actually, the right to receive that tax refund arises at the end of the taxable period. See 11 U.S.C. 362(b)(26). So, if you are filing a tax return on 4/15/2013, the right to receive the refund arose on 12/31/2012 because that was the end of the taxable period of 2012. The return on 4/15/2013 only quantifies (liquidate) how much is owed.

How this plays out is that if you owed taxes for the 2011 tax year and expect a refund for the 2012 tax year and you filed your bankruptcy petition on or after 1/1/2013, then the IRS will keep enough of your tax refund from 2012 to cover the debt owed from 2011. Any extra would be refunded to you. If there are still taxes owed from 2011, then they will either need to be paid in full in your Chapter 13 (because they would be priority debts – another post explains this) or they will still be there for you after a Chapter 7. Older tax debts may be discharged, but in this example they would not.

This is where advanced bankruptcy planning can help. If you already know you are likely to receive a sizable tax refund for the tax year you are currently in and you owe tax debt from a prior year, your best chance at keeping those funds is to file the bankruptcy before December 31.