When times get tough, you start hearing more about bankruptcy. Deciding to file for bankruptcy is a difficult choice with financial implications for years to come. Many people do not fully understand how filing for bankruptcy can affect their tax situation. Some people believe that filing for bankruptcy will discharge all tax debts. That is not necessarily true. Depending upon the type of bankruptcy you file for and the type of tax debt you have, bankruptcy may or may not help.
Regardless of what type of bankruptcy you file for, you must continue to file all tax returns and pay all assessed taxes on time. If you file late, without an extension, or miss filing altogether, your bankruptcy case can be dismissed, or the court may opt to change the chapter filing. Of course, how your taxes must be filed vary by chapter filing. Below are some guidelines for the most common types of bankruptcy filings, Chapter 7 and Chapter 13. Regardless of the chapter, please be sure to speak with a bankruptcy attorney before filing, as each case is different.
Chapter 7
In a Chapter 7 bankruptcy filing, you are liquidating all non-exempt assets to pay off creditors. All funds are put into a bankruptcy estate, which is a separate taxable entity. This means that you still file your standard 1040 returns as required, and the trustee of the bankruptcy estate must file a separate 1041 return for all assets in the estate. If you are appointed as the trustee (the “debtor-in-possession”) that means you must file two different tax returns for each year required.
To add yet another wrinkle, if you are married and your spouse is jointly filing for bankruptcy with you, even if the bankruptcy estates are jointly administered, they are still treated as two separate taxable entities. With two separate 1041 forms required for each tax years.
Tax debts may or may not be discharged in a bankruptcy case. Recent tax debts are not discharged under Chapter 7 filing. Neither are the following tax debts (including the interest tacked on):
- taxes entitled to eighth priority
- taxes for which no return was filed
- taxes for which a return was filed late
- taxes for which a fraudulent return was filed
- taxes that you willfully attempted to evade or defeat
If the case is dismissed, you must file tax returns as though the bankruptcy filing never happened. This means sending 1040X Amended Returns to replace the returns filed on behalf of the bankruptcy estate. Include all items of income, deductions and credits that were reported by the bankruptcy estate on its returns, but not included on debtor’s personal returns.
Depending upon your specific situation, you may elect to end your tax year. This creates two short tax years in the calendar year you petition for bankruptcy. So, if you file your petition on June 3, 2009, you have one tax year that runs from January 1, 2009 to June 2, 2009. The second shortened tax year runs from June 3, 2009 to December 31, 2009. This allows your federal income tax liability for the first short tax year to be an allowable claim against the bankruptcy estate as a claim arising before the filing. Any portion not subject to discharge under the bankruptcy code can be collected from the bankruptcy estate. Without this election, no part of your tax liability can be collected from the bankruptcy estate, and will be your burden come tax time.
Chapter 13
In a chapter 13 bankruptcy filing, individuals with regular income enter into a repayment plan with their creditors. Generally you keep your assets, but make payments to the bankruptcy trustee, who is appointed by the court. Chapter 13 filing can discharge recent debts, criminal fines and debts incurred by fraud. You must file all tax returns for any tax period ending within 4 years of the bankruptcy filing date or you risk case dismissal or converting to chapter 7.
In a chapter 13 bankruptcy, the court creates a bankruptcy trust account. This is not considered a separate tax entity, and you should continue to file normal tax returns. Do not include any cancelled debt at “income”. Any losses, credits or basis in property that has been reduced because of cancelled debt needs to be included on your return. Do not include interest earned on amounts held by the bankruptcy trust account prior to distribution to the creditors as income on the debtor’s return. That interest is only available to the trustee and not taxable to the trustee.
Tax debt may be discharged if you receive a broad chapter 13 discharge. However, the following are exclusions to broad discharge.
- all priority tax claims are not discharged and must be paid in full
- withholding taxes for which you are liable are not discharged
- taxes for which no return was filed are not discharged
- taxes for which a return was filed late prior to bankruptcy filing are not discharged
- taxes for which a fraudulent return was filed are not discharged
- taxes the debtor willfully tried to evade or defeat are not discharged