Tax refunds used to pay bankruptcy fees

Some Americans spend their tax refunds on high-tech gadgets and long-awaited vacations. Others use the cash to file for bankruptcy.

More than 200,000 money-strapped households will use their tax refunds this year to pay for bankruptcy filing and legal fees, says a new study by the National Bureau of Economic Research.

The NBER research confirms what bankruptcy lawyers have long known: At the first part of the year, when Americans receive their tax refunds, there almost always is a spike in personal bankruptcy filings.

But that has been especially true since the cost of bankruptcy soared after U.S. bankruptcy laws changed in 2005. And many more families have been forced to delay filing until they can afford to pay the fees, the NBER study says.

"If people are expecting a big refund, they go as fast as they can to a tax preparer," says Henry Sommer, a bankruptcy lawyer in Philadelphia. "They need the money so they can afford to file for bankruptcy."

The average cost of legal and administrative fees jumped from $921 in 2005, before the reform in the law, to $1,477 just two years later, the U.S. Government Accountability Office says.

The largest slice of the overall cost is attorney fees, because lawyers now must verify much more information in a case than they did before 2005, says Robert Lawless, law professor at the University of Illinois. "Like any other professional services, the longer something takes, the more it costs," he says.

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The law was changed to prevent bankruptcy abuse. It was thought that too many people who could afford to pay their debts were taking advantage of the system.

"But if you want to curtail abuse, raising the cost is not a good way to do it," says Jialan Wang, assistant professor of finance at Washington University in St. Louis and an author of the NBER study. "The people who really need bankruptcy are the ones who will be unable to pay for the fees."

Those who have trouble saving money will delay filing for bankruptcy until they have a one-time cash infusion, such as tax rebates or tax refunds. Last year the average tax refund was $2,913, NBER says. That's enough for many Americans to file for bankruptcy.

Since the law changed, fewer people have filed for bankruptcy. But that doesn't necessarily mean that the change has curtailed abuse of the system. "It just means that financially distressed people are not necessarily getting the help they need," Lawless says.