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How are windfalls treated during bankruptcy?

Creditors benefit when a windfall is received during a bankruptcy

When an inheritance, a lottery win or another lump sum is received by debtors, the U.S. Bankruptcy Court is likely to view it as money that should be used to pay their creditors.

For those involved in a Chapter 7 liquidation case, the windfall would be applied before a discharge of debts is approved. In Chapter 13, in which a court-ordered repayment plan takes from three to five years, the money is typically incorporated into the payments before the plan is completed.

In either case, the court must be informed of a windfall to determine how it will be used. If there is a surplus once creditors are paid, the remainder may be returned to the individual. Any exceptions granted by the court are based on what type of lump sum has been received. Some are covered by exemptions or allowed because they are payments to a crime victim or for a personal injury.

It is a person's disposable income, above reasonable household and family expenses necessary to maintain an average lifestyle, that determines how much in monthly payments the Chapter 13 debtor must pay to creditors.

"The key question is often, 'Is this money considered to be disposable income that you are required to turn over to the trustee?'" writes New York attorney Peter Orville for Bankruptcy Law Network.

Tax refunds

People whose income falls below the median in their home state and who have passed the three-year point in the bankruptcy will probably be able to keep the money, states Orville. For those who are an over-the-median debtor and have made payments for fewer than three years, the additional funds are likely to be considered part of their disposable income.

Another payment that may be considered a windfall by the court is a sizable IRS tax refund. The money may be absorbed into creditor payments or covered by one of several exemptions that debtors are allowed to claim, including a "wild card" federal exemption. In Chapter 13 cases, the refunds are considered property within the debtor's estate.

While state laws vary widely regarding tax refund exemptions, most trustees base their handling of these payments on the amount of money returned and how much can be paid to creditors of unsecured debts.

"If the total amount is small and the percentage paid back would be insignificant, the trustee is likely to abandon the tax refund and allow you to keep it," states Oklahoma attorney Dan Nunley on his website.

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