All right, so many (but not all) people who file Chapter 13 Bankruptcy are required to turn over a portion of their tax refunds. Tax refund policy varies from district to district. In the Eastern District of Wisconsin, below median debtors are required to turn in one half of their net tax refunds each year that they are in bankruptcy (typically 3-5 years).
Why does tax refund money ever come in to a bankruptcy case? Under Chapter 13, all “disposable income” (a term that elicits its own discussion for another time) is required to be turned over to the bankruptcy estate for the benefit of creditors. Tax refunds represent surplus disposable income that was withheld from someone’s wages (or other form of income) in excess of what should have been withheld. Meaning, if the debtor had less money deducted from his paycheck (resulting in no tax refund), there would be more money on the paycheck to pay creditors.
Why not the full tax refund? To provide an incentive for the tax payer to prepare his/her taxes in such a way as to take advantage of any eligible deductions and credits so as to maximize their tax refund. The Trustee isn’t able to file or even amend your tax returns for you. If the Trustee were to take the full tax refund, then there would be no incentive on your part to attempt to get any tax refund at all. By only taking half, every extra dollar you manage to secure in tax refund money means 50 cents for you and 50 cents for the Trustee.
And why only below median debtors? This is a matter of practical convention. Below median debtors never reach part 2 of the Means Test which – among other things – requires that actual tax liability be estimated and calculated, rather than what is withheld from tax withholdings (as described on Schedule I, which all debtors must complete). Since the Means Test ignores tax withholdings and focuses on actual liability, it is assumed (incorrectly, I might add) that the only way the debtor can afford to make plan payments as required under the Means Test is to adjust their withholdings in such a way that they do not receive a tax refund.
This is hardly ever true, and as I said – different districts have different approaches to tax refunds.
Who gets the money? Well, technically, tax refund money is earmarked for unsecured creditors. Since tax refund money isn’t reliable (we never know how much a debtor will receive in tax refunds during the pendency of a Chapter 13 Plan, or even if a debtor will receive any refunds), tax refund money cannot be relied upon to pay mandatory creditors holding secured or priority claims.
Most debtors, however, pay less than the full balance owed to their unsecured creditors. How much they do pay is based primarily on income. So tax refund money – if there is any – is a windfall for the unsecured creditors.
HOWEVER, the Trustee is required to pay secured and priority claims first, which means that most people who are in Chapter 13 bankruptcy – their first few tax refunds will actually go toward paying secured and priority creditors off a little faster than they would have been paid if depending only on regular monthly plan payments. As a result, unsecured creditors will start getting paid a few months sooner than originally scheduled. Those extra few months of payments eventually make up for the tax refund money which was earmarked for the unsecured creditors, but was physically turned over to the secured and priority creditors.
Which then answers the final question – does paying in tax refund money shorten the term of the Plan? And the answer is usually “no”. The amount paid to creditors is not fixed at the time your bankruptcy case is filed. There is a preliminary amount which consists of all secured and priority creditors that have to be paid in full, plus some percentage toward your unsecured creditors. Tax refund money merely inflates the amount of money going toward unsecured creditors.
Barring some other circumstance (or a plan amendment), your Chapter 13 Plan will continue for the full 3 or 5 years that you originally scheduled it for, and would only be shortened if your unsecured creditors would be paid in full.