Can you keep your tax refund through a Chapter 7 bankruptcy?  Maybe.

Everything you own when your Chapter 7 is filed makes up your “bankruptcy estate.”  Usually, most or all of that “estate” stays in your possession and you can keep it because it’s exempt (protected).  The bankruptcy estate includes not only your tangible, physical possessions, but also intangible ones—assets you own that you can’t physically touch—such as money owed, but not yet paid, to you.  A tax refund can be an intangible asset that is part of your bankruptcy estate.  Whether you can keep the tax refund depends on whether it is exempt.

Because an income tax refund usually comes from the overpayment of payroll withholding, the full amount of that refund has accrued by the time of your last payroll withholding of the tax year. So even though nobody knows the amount of your refund until your tax return is prepared a few weeks or months later, for bankruptcy purposes it is an asset of yours by January 1 of the next year.  If you file a Chapter 7 case after the beginning of the next year and before you have received your tax refund, it is part of your bankruptcy estate and the trustee can keep however much of it that’s not exempt. This is also true if you have received the refund and not done anything with it (like if you haven’t deposited the check).

You can avoid possibly having a non-exempt tax refund by filing your tax return, receiving the refund, and appropriately spending it before your Chapter 7 case is filed.  But first, you should seek advice from a bankruptcy attorney.  Your bankruptcy trustee will be interested in what money you receive and spend before bankruptcy, which can be a source of problems if it is not done carefully.

Whether or not your tax refund is exempt depends on how much it is and whether you have room to exempt it.  In some cases, using all or part of an exemption for your tax refund may reduce the availability of the exemption for other assets.  Even if the refund, or a portion of it, is not exempt, the Chapter 7 trustee might not claim it if he or she decides the amount is not enough to open an asset case.  That would be a case where the amount of refund is so small that the benefit of distributing it to the creditors is outweighed by the administrative cost involved.  This threshold amount can vary from one court and/or one trustee to another so be sure to discuss this with your attorney.  But if the trustee is collecting any of your other assets, then he or she will want every dollar of a non-exempt tax refunds.

There is a risk that you will not be able to claim an exemption if you don’t list the tax refund in your bankruptcy papers.  Be sure to always list any tax refund to which you may be entitled.

These same principles apply year-round.  By of July 1, you have had half a year of income-tax withholding deducted from your paychecks.  A bankruptcy filed on on or after July 1 should take that into account, even though some trustees don’t push this issue much until closer to the end of the year, when of the potential tax refunds has accrued.  Nevertheless, you should tell your bankruptcy attorney about income tax refunds expected in the next year, especially if you have a history of fairly large tax refunds.

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Chapter 13 can help keep certain small businesses afloat, but what about Chapter 7?  Can it be used to save a small business?

Generally, Chapter 7 is seldom a good option if you own a business that you want to keep operating.  This is because Chapter 7 is a liquidation in which the bankruptcy trustee could make you give up any valuable parts of your business.

Once a Chapter 7 bankruptcy is filed, all of the debtor’s assets are automatically transferred to a new legal entity called the “bankruptcy estate”.  A trustee is assigned to oversee this estate, which usually means that the trustee is looking for assets in the estate that are worth taking and giving to creditors.  The debtor can protect, or “exempt,” certain assets, which remain the debtor’s and cannot be taken by the trustee.  The reasoning behind exemptions is that bankruptcy filers should be allowed to keep a minimum amount assets to live on while obtaining a fresh start. In most consumer Chapter 7 cases, the debtor can exempt all their assets, leaving nothing for the trustee to take.  This type of bankruptcy is called a “no-asset” case.

Can you file a Chapter 7 and continue to operate a business?  The answer requires responses to two other questions:

First, can you exempt the entire value of the business from the bankruptcy estate?

Many small businesses are would not exist but for the services of one or two owners.  In that case, they could not be sold as a going concern separate from their owners.  When faced with this type of case, a Chapter 7 trustee must decide whether he or she can sell any of the various assets that make up the business, or whether the debtor can exempt all of its assets.

The assets of a small business can include tools and equipment, receivables (money owed by customers for goods or services already provided), supplies, inventory, and cash.  There may also be value in a brand name, a below-market lease, or some other unusual asset.

If all of a business’ assets can be exempted in bankruptcy, it is possible for the owner/debtor to have a no-asset Chapter 7 case.

The second question is whether the trustee is willing to allow the business to operate in spite of its potential liability risks for the estate?

Recall that everything you own immediately becomes part of the bankruptcy estate once your case is filed.  One result of this is that your business becomes the trustee’s to operate.  Thus, the estate is potentially liable for damages caused by the business.  The trustee may also be liable for such damages.  That is why many Chapter 7 trustees’ want to shut down ongoing businesses where the owner is in an active bankruptcy.  The exceptions to this depend on the trustee, the nature of the business, and whether it has sufficient liability insurance.

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Bankruptcy can help both sides of your balance sheet. Getting a fresh start means not just being relieved of debt, but also protecting essential assets. You can preserve this  benefit by not selling, using up, or borrowing against your protected assets BEFORE your  case is filed. In order to regain your financial footing, you will need housing, basic household goods, clothes and – where appropriate – tools of the trade, unemployment or disability benefits and retirement savings. Bankruptcy usually protects these things. Specifically, Chapter 7 protects all “exempt” assets. And if the applicable exemptions do not protect all of your property, Chapter 13 usually provides protection. But bankruptcy cannot protect what you’ve sold, given away or used up. Clients often recount how, within the year or so before deciding to file their case, they depleted their retirement account or sold off household goods in an attempt to avoid bankruptcy. But those things usually would have been protected had they filed their case when they still had the assets. As they say, hindsight is 20/20, but if you are one of those trying to avoid bankruptcy and you are thinking of spending, selling, or borrowing against any of your assets, do you know whether it would be protected in bankruptcy? This type of decision has long-term consequences and is often made without any legal advice about the alternatives. If someone in her 50s cashes in a 401(k) retirement account to pay credit-card companies, that decision can hurt her retirement years.  Or if a couple sell a debt-free car that is in good condition, believing that they’ll lose it in a bankruptcy, that decision could adversely impact their ability to get to work. People tend to wait until they are at the end of their rope before getting legal advice, well after they have made these types of adverse decisions.  But you can obtain a better fresh start by going for legal advice early enough to preserve your assets.

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Of course, I do need to know about actual, ongoing lawsuits, but in this post I’m talking about claims the debtor might have against another individual or against a company.

Why would I want to know about possible lawsuits you might have against others that you never filed in court? Because they are assets. They are assets because, if filed, they might bring in some money to you.

Now, it’s true that court fees, attorney’s fees and expert witness fees might eat up a lot (or maybe even all) of a recovery you might get in a lawsuit, depending on how much in damages you stand to recover. But a danger of not telling the bankruptcy court about your potential lawsuits is that you might no longer have the right to sue after the bankruptcy is over.

This is because a person who is filing for bankruptcy has an obligation under the law to disclose all of his or her assets or potential assets to the bankruptcy court. When you fail to disclose a potential lawsuit to the bankruptcy court but then you later (after the bankruptcy discharge) file that lawsuit, you have taken an inconsistent position – you’ve sworn to a bankruptcy court that you had no assets other than those you disclosed, and those assets didn’t include a potential lawsuit; and yet, you then filed a lawsuit after the bankruptcy based on a pre-bankruptcy claim. The law basically says that you cannot have it both ways.

When you file for bankruptcy, a bankruptcy estate is created. All of your assets, including potential lawsuits, become property of the bankruptcy estate, except for those assets you have managed to exempt. If you do not specifically list and exempt an asset, it is property of the bankruptcy estate. The rule of thumb is that it is always a better idea to list it and exempt it than not to list it at all.

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