In Chapter 13 Bankruptcy – debtors who are below-median (or above-median debtors who amend their plan after confirmation) are required to submit 1/2 of their federal and state income tax returns to the trustee each year that they remain in the plan. (Different districts have different rules concerning tax refunds – the rule I’m describing pertains to the Eastern District of Wisconsin.) I have explained in the past why this is so, but to reiterate, it’s because people can have too much in tax withholding, which artificially decreases their disposable income while rewarding them each year with a large lump sum payout from the government. Above-median debtors are initially exempt from this requirement since they are subject to the formulaic means test which measures actual tax liability. If an above-median debtor over-withholds, in theory, they are only making it more difficult for themselves to make the plan payments.
Regardless of the equitable nature of this rule, the fact of the matter is that most people are none too pleased about having to fork over half of their tax refunds. And as your attorney, it is my responsibility to ensure that you are educated enough about your options to proceed through bankruptcy as wisely as possible.
First of all – let’s clear up two extremely common misperceptions.
ONE – Regardless of whether you are required to submit one half of your tax refunds to the trustee, all Chapter 13 debtors must submit copies of their tax returns to the trustee each year that they remain in the plan. This is for reasons separate from the tax refund issue (though the tax returns also help the trustee verify that you have paid in the correct half amount – without the tax returns, he must assume that you did not).
TWO – Tax refunds do not help pay off your bankruptcy faster (unless all debts are being paid in full). Tax refunds are earmarked for unsecured creditors – as an ADDITIONAL dividend to be paid to unsecured creditors above and beyond what you are required to pay them under other factors.
Because of distribution rules, tax refunds will be used to pay priority and secured creditors first. So, let’s say we have a plan paying $100/mo for 60 months to pay back $6k in secured debt. After two years, the debtor has paid in $2,400 and also paid in $3,600 in tax refunds. Now the secured creditor is paid off in full. The regular monthly payments ($100/mo) that the debtor will continue to pay out for the remainder of his 60 month plan (36 months) will replenish the tax refund money ($3,600) that was earmarked for unsecured creditors, but paid instead to the secured creditor. The tax refunds paid in for the remaining three years will also go to unsecured creditors, but since the secured and priority creditors have been paid in full, that money will go straight to the unsecured creditors and not part of the “replenishment”.
So, the title of this blog promised a strategy, so a strategy I shall give. And that strategy is actually really simple…
The best way to avoid your obligation to fork over half of your tax refund to the trustee is to not have a tax refund.
Does this mean you shouldn’t file your taxes? Absolutely not. Your case will either be dismissed by the trustee for failure to do so, or the IRS and state will file section 1305 claims against you in the bankruptcy, making your plan unfeasible.
What you do is adjust your tax withholding such that you get little or no refund at the end of the year. In other words, more money on your paycheck to live off of, and no large lump sum at the end of the year.
Now, how to do this is a whole different question, and that I leave to other professionals, such as tax attorneys, CPAs, or perhaps even qualified people on your employer’s HR staff.
Technically, if you have more money on your paycheck, you will have more disposable income, and therefore your plan payments would be higher. That being said – if you are below median, your budget controls feasibility, not the Means Test. Whether anyone (such as a trustee) wants to admit this or not, the budget is an art form. If there is an extra $100/mo on your paychecks, that money can often be negated by a reasonable expense with great ease.
Before I close out this post, I want to leave you with a paraphrased, but otherwise actual conversation I recently had with a client. She had come to me because she was struggling with her plan payments. I was reviewing her case to determine if there was any wiggle room. Unfortunately, there wasn’t, but I also happened to notice that she was paying in a LOT of money each year to the trustee for tax refunds – close to $10k each year.
Me: You’re paying in an awful lot of money to the trustee for tax refunds each year. Why don’t you adjust your tax withholding? That will give you more money on your paychecks, and you should be able to manage the plan payments just fine, then.
Client: I can’t. I depend on that tax refund to pay my property taxes.
Me: I understand that. But you can set that money aside – into a savings account – and pay it later.
Client: I’m not disciplined enough to save money like that.
Me: Yeah, but if you do it the way you’ve been doing it, you’re struggling with plan payments and you only get $10k to pay for property taxes. Do it the way I’m suggesting, and you get $20k each year. You’re giving up $10k to unsecured creditors each year and you don’t have to be.
Once I made the contrast clear to her, I believe my client summoned the strength to discipline herself into setting aside some of that extra money on her own. Yeah, you can look at the IRS as a savings account. But they’re holding on to your money, interest-free. And when you’re below-median and in Chapter 13 Bankruptcy, you only get to keep half. It’s better to manage the money more carefully on your own.