Tax Refunds and the IRS Right of Setoff and Recoupment

One of the most frustrating experience is that people have in bankruptcy is thinking that they will be able to keep their tax refund and then losing it to either the IRS or the trustee. With a little bit of proper planning, it is possible to protect your tax refund. As an initial matter, I need to understand two things about your tax refund. First, your tax refund is probably the bankruptcy estate. It is an asset to the chapter seven trustee can block to three payment your unsecured creditors. Second the tax refund is actually a debt the IRS owes to you. When you have a tax refund, you have made an overpayment to the US Government. Your tax refund is actually a debt that the United States Treasury owes to you.

Let’s start with tax refund as an asset of the estate. When you file bankruptcy all of your property becomes property of the bankruptcy estate. The bankruptcy estate can be administered for the benefit of your general unsecured creditors. Most of your property can be protected with exemptions. Exemptions are what allow you to keep property during and after a bankruptcy so that you can get your fresh start.

So first things first, all property the estate must be listed on schedule B. Your tax refund has to be listed on schedule B even if you haven’t prepared or filed your tax return yet. This is because the tax refund is considered a contingent and unliquidated claim of the estate. If you fail to list your tax refund on the bankruptcy petition, you may lose the right to claim exemption the refund. In addition, the trustee could file an adversary proceeding to deny your discharge.

Once your tax refund is listed on schedule B, your bankruptcy attorney can use exemptions to protect it. There are several exemptions are available to protect a tax refund. If you’re using Washington State exemptions or Federal exemptions, you can use was called wild card. The wild card but you protect up to a certain amount of cash value in an asset, regardless of what kind of asset events. This is in contrast to specific exemptions the only allow you to protect your interests in a certain kind of property, for example homestead exemption only allows you protect your homestead and cannot be extended to something like your automobile. Additionally, part of your tax refund may actually be a benefit of social security. For example the earned income tax credit is actually a social security benefit. If part of your tax refund is Social Security benefit, then it can be protected using a Social Security exemption. The availability of exemptions to protect your tax refund depends on the type of bankruptcy that you file and all the facts of your case. You will need to talk your bankruptcy attorney to determine whether you have available exemptions to protect your tax refund in your specific case.

This issue with the tax refund is the IRS’s right of setoff and recoupment. Like I said before, your tax refund is actually a debt that the U.S. Treasury owes to you. Some clients have tax debts from prior years that are dischargeable in bankruptcy as well as a tax refund due the current year. In this case, the IRS may withhold your refund even though you file bankruptcy. This is because the IRS is setting off the debt that it owes to you -your tax refund – against the debt that you owe to the IRS for back taxes. The IRS can do this even if those taxes are dischargeable in bankruptcy.

Unfortunately there is nothing that you can do about it, if the IRS decides to exercise its right of setoff and recoupment. However, filing bankruptcy now and dealing with your tax debts this year is a better strategy than waiting and letting the IRS take your tax refund year after year. If you can discharge your taxes this year, you will be protecting your tax refund for years to come.