I often describe filing Chapter 7 bankruptcy to my clients as a trade-off. Here in Arizona, that seems to work out well. You receive a “fresh start” by having debts eliminated. In exchange, a bankruptcy trustee takes any unprotected property you have, or have owed to you, on the day your case is filed.
Because the bankruptcy laws allow you to protect the most common personal and household items, most people who file for bankruptcy in Arizona don’t lose anything in Chapter 7. The bankruptcy exemptions in Arizona are very good overall, and for that we’re more fortunate than people elsewhere in the nation.
Tax refunds are a big exception in the world of bankruptcy. A tax refund is getting back the money you did not owe. It is similar to than putting money in a saving account. The right to get this money back is considered an asset when your bankruptcy case is filed.
The bankruptcy trustee can take the entire refund that is owed to you when your bankruptcy is filed for any year up to the date your case is filed. The Arizona Bankruptcy Court will also allow the trustee to prorate the refund you receive for the tax year your case is filed in. For example, a case filed on September 30, 2011 was filed on a day when 75% of the year was over.
Under the Arizona bankruptcy exemption scheme, the trustee will have a right to 75% of the 2011 tax refund.
You have a legal duty to provide a copy of your 2011 tax return to the trustee and send the refund check to the trustee. The trustee also has a right to collect the refund directly from the IRS or Arizona Department of Revenue.
There are a couple of ways to plan to avoid losing a tax refund to the Arizona bankruptcy system. One, adjust your tax withholding by filing a new W-4 Form with your employer. This form will allow you to reduce your tax withholding and either eliminate or reduce the size of the refund. It will stop the overpayment of the tax. It might be too late into the year to completely eliminate the refund.
A second option is to delay filing your bankruptcy case until after you have received the refund. This strategy should always be combined with updating your W-4 so that you do not have the same problem when your tax return is filed for the following year. You can then use that money to pay personal expenses, legal fees, or purchase things that are protected prior to filing your bankruptcy.
In some states, protecting your tax refund is a given. Not so in Arizona. When Congress wrote the bankruptcy laws they allowed each state to determine what property will be protected for the cases filed in its state.
This is another example of how important it is to make sure you receive up to date advice based on your situation.
