Chapter 13 Bankruptcy, Tax Refunds, and Funding the Plan

In my previous article, I discussed protecting tax refunds in Chapter 7 bankruptcy. However, in Chapter 13 bankruptcy, the focus shifts from asset liquidation to disposable income and plan funding.

In a reorganization, a tax refund could affect your plan payments, but also allow you to qualify for Chapter 13.

By Alexander Hernandez, J.D., Professor, and Author of Consumer Bankruptcy Law (Routledge).

Key Takeaways: Chapter 13 Bankruptcy and the Tax Refund Strategy

• The “Disposable Income” Test: In a Chapter 13 reorganization, the court views your tax refund as projected disposable income that belongs to the plan.
• Proving Feasibility: For debtors with a tight monthly budget, a consistent annual tax refund can be used as evidence to the Court and the Standing Trustee that you have the ability to fund the plan.
• Lowering Monthly Payments: By applying your tax refund toward arrears on secured debt like a mortgage or car payment, or priority unsecured debts like back taxes, you can significantly reduce the monthly plan payments.
• The “Tax Refund Kickstart”: Tax season is often the best time to file because the refund can be used toward attorney’s fees.

The Chapter 13 Bankruptcy “Disposable Income” Test

In Chapter 13, the Trustee generally views a tax refund as projected disposable income. Because you are required to commit all your extra income to the plan for 36 to 60 months, the court often expects those annual windfalls to be paid into the plan for the benefit of your creditors.

Compliance and Updated Financials: You are legally required to provide the Trustee with a copy of your federal tax return every year while your case is active.

The Modification Trap: If your income increases significantly (as evidenced by your return), the Standing Trustee may move to increase your monthly plan payments.

Professor’s Note: The same way plan payments may increase because of tax refunds, bonuses, commissions, or even a wage increase, it could also decrease. However, a downward modification must prove that creditors still receive their share, especially unsecured creditors, by using the Chapter 7 Liquidation Test.

Unfortunately, this puts many debtors in the situation where they have to continue funding the plan even though they have had a substantial drop in income.

Using the Tax Refund to Prove “Feasibility” and Qualify for Chapter 13 Bankruptcy

One of the biggest hurdles in Chapter 13 bankruptcy is proving feasibility, the legal requirement that you can actually afford the plan payments you’re proposing. This is where the “tax refund kickstart” comes in.

If a debtor’s monthly budget is razor-thin, then your bankruptcy lawyer can argue that the anticipated tax refund should be prorated to cover the “shortfall” in monthly payments.

Example: If a debtor is $200 short on their required monthly payment, but consistently receives a $2,400 annual tax refund, the bankruptcy plan can be used to show that the tax refund will fill in the gap.

Strategy: Adjusting Withholdings vs. Turnover

There are two primary ways to handle the “Refund Issue” during your plan:

Strategy	How it Works	The Benefit
The Turnover	You keep your withholdings the same and “hand over” the refund to the Trustee every spring.	It acts as a forced savings account to ensure the plan stays on track.
The Adjustment	You adjust your W-4 so you take home more money each month and receive a $0 refund.	Increases your monthly cash flow, making it easier to pay regular bills without waiting for a lump sum.

Using the Tax Refunds for Attorney’s Fees, Catching Up On Arrears, and Priority Unsecured Debts

In practice with my bankruptcy clients, I have used the initial tax refund as evidence that the debtor can afford the plan. In my experience, the Standing Trustee isn’t likely to object as long as the plan payments are made timely and the refund is applied the following year.

The tax refund can also be used for attorney’s fees, whether in Chapter 7 bankruptcy or Chapter 13. For this reason, tax season is busy for bankruptcy lawyers, and filings tend to increase.

The tax refund can also be used for catching up on the arrears on secured debt or priority unsecured debts, such as taxes. This will also lower your monthly payments because of the lump sum.

The Professor’s Conclusion

In Chapter 13, a tax refund isn’t just “extra money.” The tax refund can be used as a strategic asset to help you qualify for Chapter 13, including lowering your payments by using the lump sum to catch up on arrears.

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