Will I Lose my Tax Refund if I File Bankruptcy?

Here’s a common fact pattern.  A taxpayer files bankruptcy in June of a tax year and receives an IRS tax refund in April of the following calendar year.  What happens to the non-exempt portion of the IRS tax refund?  The taxpayer would want to keep the refund, but the Chapter 7 trustee would want a turnover of the refund for the benefit of the unsecured creditors.

That issues was addressed in In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, the parties agreed that the taxpayer should be allowed to keep the portion of the tax refund representing income earned after the bankruptcy case was filed to December 31.  The IRS argued that the taxpayer should be allowed to keep the same percentage of the tax paid after filing bankruptcy to the total tax refund; so if 25% of the tax payments were tendered after filing bankruptcy, then the taxpayer would be allowed to keep the same 25% of the total refund.

The Mooney court, rejected the IRS’ approach and adopted a “pro rata by days approach.”  Id. at 428.  The court held that the refunds should be prorated to the date of filing based on the number of calendar days before and after the bankruptcy filing date.  So, since the taxpayer filed bankruptcy on the 177th day of the year with 188 days remaining, then the trustee would be allowed to seize the percentage of the total refund that reflects 177/366, or 48.49%.  Similarly, the taxpayer would be allowed to retain the percentage of the total refund that reflects 188/365, or 51.51%.

Practice Pointer:  File as early in the calendar year as possible if a taxpayer is expecting a large refund. An early filing preserves the argument that the income was earned after the bankruptcy filing and the maximum share of the tax refund would be protected by the taxpayer.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Leave a Reply