Think of the refund as money you gave to your “uncle” to hold for you until after your bankruptcy was filed.  Here is how it works:

When your employer pays you, the employer is required to withhold a portion of your earnings for payment of various taxes including the state and federal income tax.  These withholdings are sent to the federal IRS and state Department of revenue but the money still belongs to you until the amount of your tax liability is determined from the tax return you filed.  If the amount withheld by your employer exceeds the tax liability, you are owed a refund.

Income taxes for a given year are generally due by April 15 of the following year.  If you filed your tax return early in the year during which you filed bankruptcy, you may have received your tax refund and spent the money before you filed bankruptcy.  This is the best practice and that is why we routinely advise our clients to file their tax return and spend the tax refund before filing bankruptcy.  If you are not going to receive a tax refund, there is no refund for the trustee to claim.

If you are owed a refund or if you have received the refund and not spent the money before you filed bankruptcy, the trustee will claim that money as a non-exempt asset which is part of the debtor’s estate to be administered by the trustee for the benefit of the creditors.  So, even though you have already filed bankruptcy, if you receive a refund that was from tax withholdings on earnings prior to the date you filed bankruptcy, the refund is going to be claimed by the trustee.

The trustee, for the benefit of your creditors, is entitled to any of your money which the government (your “uncle”), or anyone else, was holding for you as of the date you filed bankruptcy.  One exception is that you have an exemption for up to $150 per debtor for money in one bank account.  You can also exempt money held for you in a qualified retirement account.  The tax refund is not exempt.

If your tax liability for 2009 was determined prior to the date you filed bankruptcy, and you were not entitled to a refund, or if the refund check was already sent to you and spent by you prior to the date you filed bankruptcy, the trustee is not going to get anything because, as of the date you filed bankruptcy, the government was not holding any of your money.

As for the trustee’s claim to any tax refund owed to your from over-withholdings paid to the government during the same year you filed bankruptcy, that claim is limited to a pro-rata share of any refund attributable to the money withheld from your earnings prior to the date you filed bankruptcy.  If you filed bankruptcy half way through the year, the trustee will claim ½ of the refund you receive the next year.

If you typically get a refund each year, you are over-withholding.  You are depriving yourself of the use of some of the money you earn each pay period and sending that money off to the government to hold until it is time to calculate your tax liability.  You may need the help of some tax advisers to calculate the amount you should withhold or you may just need to speak with someone in your employer’s HR department.  The best practice is to end up with no surprises when tax time rolls around each year.  Remember, in the context of bankruptcy planning, over-withholding can result in losing some of your money to the trustee for the benefit of your creditors.

Many trustees will not claim a small refund for the estate because the amount involved is too small to justify their time and expense.  This is especially true if the tax refund is the only non-exempt asset to be administered.  If you send your tax refund check to the trustee, the trustee will calculate the amount that can b be claimed by the estate and may decide to abandon that claim and return the check to you.