Most individuals file for either Chapter 7 or Chapter 13 bankruptcy. In Chapter 7 bankruptcy, the bankruptcy trustee collects and liquidates all your nonexempt assets and disburses the proceeds to your creditors. Any eligible debts that remain unpaid are discharged, meaning they are no longer your responsibility. In Chapter 13 bankruptcy, you don't give up your assets. Instead, you enter into a three- to five-year repayment plan in which you pay some or all of your debts. Any eligible debt left over is discharged, just as in a Chapter 7 proceeding.
Chapter 7 and Refunds
In bankruptcy, a tax refund is considered an asset. If you file for Chapter 7 bankruptcy, that means you must disclose its existence to the bankruptcy trustee so he can liquidate it along with your other assets. The only way you can prevent this from happening is to find an exemption for it under federal or state law. Exemptions are categories of property that may be protected from seizure, up to a prescribed dollar amount. While there isn't a specific exemption for tax refunds under either federal law and most state laws, you can protect your refund using the popular "wildcard" exemption. This is a catch-all category that allows you to protect whatever property you want, up to a certain value. Depending on your state, you may be able to choose between either the federal or state wildcard exemption, or you may be limited to your state's wildcard exemption only.
Chapter 13 and Refunds
Since assets are not seized in Chapter 13 bankruptcies, you are not required to hand over your tax refund to the bankruptcy trustee. However, you still must disclose the existence of these funds because the trustee will include them in the calculation of your disposable income. In general, the trustee will take your income from all available sources and subtract reasonable and necessary expenses -- such as food, rent and utilities -- to come up with your total disposable income, which is then used to establish your monthly payments under the repayment plan.
If you are unable to exempt some or all of your refund in a Chapter 7 bankruptcy, whatever is not protected must be handed over to the bankruptcy trustee. If you fail to do so and the trustee later finds out, your bankruptcy discharge will be denied or revoked. This means your debts will not be discharged and you will continue to owe them. So not only will you have lost your assets to seizure, including the tax refund, but you will still owe the debts you were attempting to extinguish with bankruptcy in the first place. With a Chapter 13 bankruptcy, the trustee has the option of dismissing your case, making you once again responsible for the debt, or converting it into a Chapter 7 bankruptcy, if you qualify, which means you'll have to give up the refund and all other assets.
Occasionally, a bankruptcy trustee will choose not to seize a tax refund or incorporate it into a repayment plan. There are a number of reasons why this may happen. Sometimes, for example, the bankruptcy debt is satisfied by the inclusion of other assets or income. Other times, the debtor might demonstrate an extraordinary need for the funds.