Kentucky Bankruptcy Law

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Taxes & Bankruptcy

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.

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December 27, 2013 Posted by | attorney fees, Bankruptcy, Chapter 13, Chapter 7, Plan, Tax Debts, Tax refund, The estate | , , , , , , , , , , | Leave a comment

Things to be aware of when facing bankruptcy 9

If you have made it to an attorney and are preparing to file bankruptcy, then you have received a packet requesting a lot of information including a list of assets. Be sure to be complete in listing your assets. Now, I do not mean you need to count your skivvies or socks, but you do NOT want to exclude items of value (yes, do give an estimate of the number of outfits and wearing apparel in your household but no need for an exact inventory unless they are fancy designer clothes).

A few things that tend to get left off that list: life insurance policies (even term policies that have no cash value need to be listed), burial plots, and tax refunds. These are all out of sight and out of mind things that, nevertheless, are assets of your estate. Most people have enough exemptions to cover them, and so there is no down side to listing them. The up-side to listing them is a smooth bankruptcy.

November 4, 2013 Posted by | Assets, Bankruptcy, Chapter 7, Discharge, Exemptions, Planning | , , , , , , , , , , , | Leave a comment

Chapter 13 and Tax Debt: The surprise at the end of the rainbow

I have often written about Chapter 13 and how it is a great mechanism for resolving tax debt. And it is! When looking at income tax debt, there are basically two kinds: that which can be discharged and that which cannot be discharged. Simple enough.

The basic rules of figuring out which tax debts can be discharged are also simple, but the various times and ways the time-frames of these rules get “tolled” gets tricky:

  1. The most recent date (remember extensions) the filing was due is over three years ago.
  2. The tax was assessed at least 240 days ago.
  3. The tax return was actually filed more than two years ago.
  4. The tax return was not fraudulent.
  5. The taxpayer was not willfully trying to evade the taxes.

So, in a Chapter 7 or 13, the income tax debts that meet these rules get discharged. If there are tax debts that are not discharged, then in a Chapter 7 they keep on accruing interest and penalties and must get paid. In a Chapter 13, these non-dischargeable tax debts must be paid in full. So, if you have enough disposable income to accomplish it, then in three to five years the tax debt PRINCIPAL is paid in full on tax debt that cannot be discharged.

Ahhh, the rainbow is at hand! Oh, but wait, Federal tax debt can still accumulate 4% interest while in bankruptcy and Kentucky income tax can accumulate 5% interest. You see, 11 USC Sect. 1322(b)(10) has a little catch. A debtor in Chapter 13 can ONLY pay the accruing interest on these income tax debts IF AND ONLY IF all the claims filed by creditors are paid at 100%.

There is nothing for it other than to give plenty of advance notice to Chapter 13 debtors. There is no way to change the fact that the interest can accumulate and there is no way to make it get discharged. So, unless you have a 100% Chapter 13 plan, be prepared to have to pay the accumulated interest on your income tax debt EVEN after the Chapter 13 is closed out. Don’t fret too much though. When you have gotten that far, you are going to be much more freed up financially to take care of that last issue.

September 25, 2013 Posted by | Additional Debt, Bankruptcy, Chapter 13, Chapter 7, Discharge, Disposable Income, Plan, Priority debt, Tax Debts | , , , , , , , , , , , , , | 2 Comments

Tax Refunds: A “hidden” bit of disposable income

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.

July 25, 2013 Posted by | Bankruptcy, Chapter 13, Discharge, Foreclosure, Plan payments, Planning, Pre-filing planning, Priority debt, Secured loan arrears, Tax refund, The estate | , , , , , , , , , , | Leave a comment

Tax debt information from the Judge Joe Lee Bankruptcy Institute

Here are a few more insights gleaned from the 16th Bicentennial Judge Joe Lee Bankruptcy Institute I attended last week. Professor Jack Williams gave an informative talk on the intersection between tax law and the bankruptcy code. Here are a few bullet points pulled from that talk:

  • The tax law, contained in Title 26 of the United States Code contains a key provision related directly to bankruptcy. 26 USC Sect 1398 is a must see when a debtor comes into bankruptcy with significant tax liabilities. One thing this law does is allow a debtor to bifurcate (split) their tax year into two short tax years. One reason this matters is that it would make it clear that tax liability arising from assets of the estate post-bankruptcy remain the liability of the estate rather than the debtor. Another way it may come into play is to insure that priority tax debt derived from pre-filing income will get pulled into and paid in full through the plan in a Chapter 13.
  • When looking at tax liability, look at the nature of the taxes. For example, trust fund tax liability that an employer debtor should have paid on behalf of their employees will be imputed as the debtor’s personal liability if the employer owned a pass through single member LLC. This debt never becomes stale – that is, it will never become non-collectable or get discharged. However, personal income tax liability will become non-collectable or get discharged at some point.
  • With tax debt, time is usually the debtor’s friend. If a tax return was filed, the IRS has only three years in which to challenge it. And, once a tax is assessed, the IRS only has ten years to collect it unless a bankruptcy, installment agreement, or offer in compromise tolls that time. So, if a debtor can wait it out, they may be better off.
  • If, though, a bankruptcy is necessary, the timing of filing still matters greatly. The overly simplified timeline is that when three years have passed from when a tax became due, unless it has been tolled for some reason, then those taxes will be discharged in a bankruptcy. If it has been more than 240 days from when the IRS assesses a tax, then that tax may be discharged in a bankruptcy. So, one must look carefully at these and try to time the filing of a bankruptcy to discharge most or all of the tax obligation.
  • It is ALWAYS better to file a tax return even if the debtor cannot pay the tax. Failure to file a return does not stop the obligation from arising. But, filing the return starts the time limitations running on the IRS and stops the IRS from assessing their own version of tax liability, absent deductions, against the debtor.
  • The worst tax scenario is the tax debt is non-priority debt but it is not discharged because of some kind of bad act such as fraud. This is because if it is priority tax, then it would get paid first and in full in a Chapter 13 or at least paid first in an asset Chapter 7. But, if it is not priority, then it only gets the same pro-rata share as general unsecured creditors and still hangs around after discharge.

The ringing wisdom of this presentation confirmed the approach I adopt when tax debt is at issue and that is to be patient, thorough, and wait when possible.

June 10, 2013 Posted by | Bankruptcy, Chapter 13, Chapter 7, Plan, Planning, Pre-filing planning, Tax Debts | , , , , , , , , , | 1 Comment

What happens to my tax refund in a Chapter 13?

A couple days ago I addressed an issue that can arise over large tax refunds in a Chapter 7. It will help you understand this post if you go back and read that one. In a Chapter 13, instead of a large tax refund threatening to knock your out of a Chapter 7, the threat is to your plan payment. In Kentucky and many other districts, the Chapter 13 plan payment is determined by your Schedule I income minus your Schedule J expenses. The trustee in the Chapter 13 examines your income to make sure it is accurate and scrutinizes your expenses to make sure they are reasonable.

Part of this analysis of expenses includes a look at your tax refund. If you have a sizable tax refund (some say over $1,200.00), then the trustee may demand that your pay the excess into the plan. So, if you receive around $6,000.00 total in refunds each year, then the trustee will argue that you can pay about $500.00 more per month into your plan.

If you have a sizable refund for this past tax year but you have reason to show that it will not be like that going forward, then be sure to make that argument. Changes is deductible expenses or number of dependents can help show that last years refund was a fluke. However, you will want to make sure that the number of exemptions you claim through your employer is correct so that you have only a small refund next year. If you have a large refund again, the trustee will demand and increase in your plan payments.

April 12, 2013 Posted by | Bankruptcy, Chapter 13, Plan, Plan payments | , , , , , , , , | 1 Comment

What happens to my tax refund in a Chapter 7?

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.

April 10, 2013 Posted by | Bankruptcy, Chapter 7, Tax refund, The estate | , , , , , , , | Leave a comment

What happens with my tax refund in bankruptcy?

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.

April 8, 2013 Posted by | Bankruptcy, Chapter 13, Chapter 7, Exemptions, Plan, Plan payments, Tax refund, The estate | , , , , , , , , , , , , | Leave a comment

Tax day, April 15th, is almost upon us!

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.

April 1, 2013 Posted by | Bankruptcy, Chapter 7, Means test, Tax refund | , , , , , , , , , , | 1 Comment

Can I keep my tax refund?

Timing is very important when considering bankruptcy and during the tax season one aspect of timing is when to file in regard to when one will be receiving their tax refund. This is one of those fact driven determinations where no one answer can be given in a general post like this, so be sure to consult with an attorney about your particular situation. What is surprising to many, though, is that even though they have not yet received their refund check, it is an asset of a bankruptcy estate. This is because they have already earned the money prior to filing a Chapter 7. So, if one files a Chapter 7 today and then receives their refund next week, the trustee can take that money to distribute to creditors.

Here is where making a decision on filing gets a little more complicated. Each person has certain exemptions they can use to hold onto property and assets through a Chapter 7 bankruptcy. If you have sufficient left over exemptions to cover your tax refund, then it does not matter if you file before or after receiving it. However, if you do not have spare exemptions, but you still really need to file a Chapter 7 soon, then it would be best to try and get that refund before filing.

Now, it becomes important to use that refund money carefully to keep from getting on the wrong side of the trustee or the bankruptcy code. The guiding idea is to use it for necessities for your family and NOT to pull one over on creditors. You cannot use it to buy luxury items (there is a specific dollar amount limit in the code) and you cannot use it to pay one creditor over others.

You can use it to buy necessities. For example, stock up on food stuffs and if your clothes are getting threadbare, get a few items of clothing but be REASONABLE about it. If you have children, get them some school clothes if they actually need them. Do not get fancy clothes – just basic items. In doing this, you are basically converting non-exempt cash into exempt personal property. You could also use the refund to pay for the bankruptcy. AGAIN: Consult with an attorney regarding your particular situation and plan and do not blindly apply these general principles to your particular situation because there are limits to personal property or household items exemptions.

March 20, 2013 Posted by | Bankruptcy, Plan, Planning, Pre-filing planning, Property (exempt | , , , , , , , | 2 Comments