Filing for bankruptcy can stop a tax refund offset initiated by a private creditor such as a credit card company or collection agency. However, if the reason for the tax refund offset is due to back taxes, spousal or child support, filing for bankruptcy may not stop the offset. Back taxes, spousal support and child support arrears are also generally not dischargeable in bankruptcy (taxes may be, depending upon how old the debt is and when the taxes were assessed).
Automatic Stay in Bankruptcy
When you file bankruptcy, the bankruptcy court grants you an automatic stay against all collection actions by private creditors. The automatic stay applies to all current and future collection actions for debts you owed at the time you filed the bankruptcy case. This means if a private creditor is currently garnishing your wages, or offsetting your taxes, the garnishment and tax offset must stop once you file for bankruptcy. The automatic stay prohibits creditors from starting any new collection actions against you. The automatic stay typically lasts until the court discharges your bankruptcy. Creditors cannot collect on debts discharged in bankruptcy.
Pre-Bankruptcy Income Taxes
If you owe a federal or state tax liability assessed before you filed for bankruptcy, but you are owed a refund in the current year, the IRS may still offset your federal tax refund unless the taxes are dischargeable. For example, you file your federal taxes on April 15, and have a refund due of $5,000. Upon processing your return, the IRS determines you owe back taxes from the prior tax year totaling $1,000. You file for bankruptcy on May 1. Since both the tax debt (a pre-petition liability) and the tax refund (a pre-petition asset) attached to you prior to your bankruptcy filing, the IRS can offset your federal tax return for $1,000 for the back taxes owed. It must then return the remaining $4,000 tax refund to you or your bankruptcy trustee, depending upon the circumstances. Check with your bankruptcy attorney if you owe back taxes to see if any of it may be discharged.
Post-Bankruptcy Income Tax Refunds
If you owe income taxes from before you filed for bankruptcy but you do not receive a tax refund until after the bankruptcy is filed, the IRS claims it has the right to offset your taxes, but many bankruptcy courts disagree. For example, you file for bankruptcy on January 1. On April 15, you file your federal taxes and have a refund due of $5,000. Upon processing your return, the IRS discovers you owe back taxes from five years ago for $1,000. In this case, the back taxes are a pre-petition debt, while the tax refund is a post-petition credit. The IRS holds that it still has the right to offset, and it may do so, while many bankruptcy courts hold that the IRS does not have the right to offset (although in a Chapter 13 case, this may not be true). Your attorney will know the law in your jurisdiction.
Past Due Spousal and Child Support
If you have domestic support orders such as child support or spousal support that are in arrears at the time you file for bankruptcy, the U.S. Department of the Treasury’s Financial Management Service (FMS) can still offset your federal taxes. FMS will send any amount of your refund remaining after deducting your domestic support order arrears to you or your bankruptcy trustee depending on the circumstances. Domestic support obligations are never dischargeable in bankruptcy.
- U.S. Courts: Discharge In Bankruptcy
- American Bankruptcy Institute: U.S. Bankruptcy Code, Section 362 - The Automatic Stay
- IRS: Chapter 7 Bankruptcy – Liquidation Under the Bankruptcy Code
- IRS: Chapter 13 Bankruptcy – Voluntary Reorganization of Debt for Individuals
- U.S. Courts: Process - Bankruptcy Basics