Bankruptcy and Taxes
Bankruptcy allows consumers and businesses to repay their debts under the protection of the federal bankruptcy court. Before calling a bankruptcy lawyer, read the following to get an idea of the details and steps of each type of bankruptcy.
Types of bankruptcy
Someone filing Chapter 7 bankruptcy, also known as liquidation bankruptcy, is looking to eliminate future obligations on their discharged debts. The debtor will give up their rights to handle their own debts. A trustee oversees them and pays creditors with any of the debtor’s assets that are not exempt under federal or state law. What most do not know is this type of bankruptcy does not take care of most mortgages or tax liens. If the debtor wants to keep the item that is being used for security on a loan, such as a house or car, they must continue to make these payments. The other option is to give up the property to remove the tax lien. Debts like most school loans, child support or alimony cannot be discharged. Another reason someone would want to experience debt relief under Chapter 7 bankruptcy is to bring up their credit score. This can be done if they can make the monthly payments on the items they want to keep and if they qualify under bankruptcy law.
Large businesses can file for bankruptcy under Chapter 11 to reorganize their debts while in operation. This type of bankruptcy is helpful for corporations, partnerships, and limited liability companies since they are not allowed to use Chapter 13. Large businesses who file bankruptcy under Chapter 7 must end operations.
Farmers and commercial fishermen can file for bankruptcy under Chapter 12 to reorganize their debts while continuing operations. This will allow the debtor to make seasonal payments when they earn their money. The debt limits for Chapter 12 are much higher than Chapter 13 bankruptcy.
Once the court approves a payment plan, Chapter 13 bankruptcy allows for all or part of their tax debts to be paid over a period of 3 - 5 years to the trustee. Most of the remaining tax debt and interest will be discharged if it was not fully paid during the agreed time period. Long-term debts like home mortgages must be paid monthly except for the payments due when filing the bankruptcy case. For example, if someone is behind three months at $500 per month, the $1,500 plus additional fees will be spread through the plan. The long-term debt will be current when the plan is completed and the payments will continue. To qualify for Chapter 13 bankruptcy, the debtor must be an individual or a husband and wife.
Discharging tax in bankruptcy
In Chapter 7 bankruptcy, you can wipe out most federal income tax debt if you fall under these guidelines.
- The taxes must be from income. Any other taxes cannot be eliminated in bankruptcy.
- Bankruptcy cannot help if you have filed a fraudulent tax return or willfully attempted to evade paying taxes.
- The debt you are filing bankruptcy for must have been filed at least three years prior. Most courts view a late return as not filing and will not discharge the tax.
- The debt must be assessed by the IRS at least 240 days prior to filing for your bankruptcy petition. This time limit can be extended if the IRS quit collecting because of an offer in compromise or previous bankruptcy filing.
Tax debt not eligible for discharge include:
- tax penalties from tax debt
- tax debts from unfiled tax returns
- trust fund or withholding taxes
Federal tax liens
If you have a federal tax lien, you know that your personal property is held by the IRS until the tax debt has been paid. While Chapter 7 bankruptcy will wipe out the debt you are filing for, if the IRS recorded a lien, it will remain. Therefore, you must clear the title by paying off the tax lien.
Bankruptcy filing tips
If you are thinking about filing for bankruptcy, keep these tips in mind:
- Seek a bankruptcy attorney and inform them whether you have filed a return for the last three years.
- Consider filing an income tax return this year before you file for bankruptcy unless you have reason to believe you will receive a large return.
- Make sure the bankruptcy attorney has all your tax records. The trustee will ask you how you have spent any refund money, so it is a good idea to have an explanation.
- Do not pay bills with this year’s refund money. It will slow down the bankruptcy case process if you do.
- To prevent further problems, file your taxes on time every year. The IRS will find out if you owe them and will charge penalties for failure to pay and failure to file.
Filing taxes after bankruptcy
A 1040 and 1041 form must be filed after a bankruptcy petition. If you have filed Chapter 7 bankruptcy, you will file your 1040 as usual. The trustee will file a 1041. Debtors filing bankruptcy under Chapter 11 acts as the trustee. They must file a 1040 individual return and the 1041 bankruptcy estate return.
Debtors must file taxes each year to keep up on new tax payments after filing Chapter 11 or 13 bankruptcy. Failure to do so can result in the bankruptcy converting to Chapter 7 unless the case is dismissed early. If you do not pay post-petition taxes in a Chapter 7 bankruptcy case, it will not affect the bankruptcy or tax debt. If you have additional questions about the details of bankruptcy, contact a bankruptcy Expert.