Debtors Think Their Plan Will Protect Tax Refunds From Chapter 7 Trustee

Tax refunds due on the date you file for Chapter 7 bankruptcy are part of your bankruptcy estate, and consequently, the trustee will make you turn over your tax refund. Refunds due for current and past year’s tax returns are at risk. I had a telephone consultation with a couple from south Florida who think they found a loophole in the collection of tax refunds in bankruptcy court. Their plan may work, but I do not think the plan is proper or honest.

These prospective debtors had not filed their 2008 or 2007 tax returns. The knew they would owe penalties. The reason they said their returns were not yet filed is that they were gathering documentation of substantial additional tax losses for both years. With the losses included, they were confident they would receive a substantial tax refund for both years notwithstanding late filing penalties. If they filed returns now, without documentation or amount of eligible losses, they would owe the IRS taxes and interest on top of the late filing penalties.

Here’s the plan they came up with. They said they were going to file the tax returns now without the expected losses. The returns would show significant tax liability. They had no money to pay these taxes, but they figured it would take the IRS months to review the 2007 and 2008 returns and to ask for payment. Even if the IRS asked them for the tax money they felt they could work out a payment plan with the IRS. After filing these tax returns, they would proceed to file Chapter 7 bankruptcy and file with the trustee their 2007 and 2008 returns showing taxes owed.

At some point after filing bankruptcy they would finally gather information about their tax losses for the same year. They felt it may take several months before they could capture all losses. At that point, they would file amended tax returns which would change a tax debt to a significant tax refund and wipe out all interest. By then, the bankruptcy would be discharged and closed.

This plan may work in practice. Debtors must file tax returns, but there is never, or rarely, a request for amended tax returns. Trustees almost never check for future amended tax returns that show greater tax refunds. The problem is that if debtors expect a future tax refund, even if delayed until amendments are filed, they are required to disclose their expectancy on their bankruptcy schedules. And, if a trustee asks these debtors (as they often do) if they expect any tax refunds the debtors would have to lie in order to hide their planned amended tax returns.

Like many debtor bankruptcy schemes, it may work if creditors don’t find out you lied.