When you find yourself overwhelmed by debt, you might start searching for options to help you get out from underneath such a burden. For many people, the best course of action to take is bankruptcy. Prior to submitting all the forms to complete your bankruptcy, it is important you fully understand how it affects your taxes, including whether or not it will discharge your federal tax debt.
The type of bankruptcy you have determines its impact on your present and future taxes, as well as any back taxes or tax debt. For a quick recap, there are several types of bankruptcies, but the most common are Chapter 7, Chapter 11, and Chapter 13.
• Chapter 7: Individuals or businesses can file for this type of bankruptcy. Your assets are liquidized to pay off any unsecured debt, with the rest discharged. Any secured debt will be repossessed, will have continued payments, or be settled with a lump sum for the current value of the property.
• Chapter 11: Typically used for businesses rather than individuals. It might be used for individuals who have a number of nonexempt assets or whose debt exceeds the limits for Chapter 13.
• Chapter 13: To file for it, you must have a reliable source of income that will help to pay off your loans over time. A repayment plan is created to help pay off your debts over a period of time, typically three to five years.
Each one has certain criteria you must meet in order to file for it. If you are considering applying for one of these bankruptcies but the bulk of your debt comes from taxes, you might want to consider one of the other tax relief options, such as Penalty Abatement, Offer in Compromise, or Installment Agreement. Contact us at 877-372-2520 for a free consultation to discuss your options.
How to File Your Taxes During or After Bankruptcy
Normally, any canceled or discharged debt is considered income for your federal tax return. However, the debt that is canceled through bankruptcy falls under a special category that is excluded from this determination. Although you do not have to worry about it affecting your income for your tax return, there are some other important factors to know.
For one, it is essential that you file your federal tax returns, whether for yourself, your business or your estate. If you do not file a return, or ask for an extension, then your bankruptcy case might be dismissed or converted, according to the IRS Publication 908, Bankruptcy Guide. On these returns, you will be unable to deduct any expenses, such as legal fees, for filing personal bankruptcy. However, if you are filing for bankruptcy for your business, then you might be able to deduct your expenses.
If you have already filed for bankruptcy, then you have to follow a slightly different routine to file your taxes. There will be two tax returns filed for you if you file under Chapter 7. You will file your normal 1040 personal tax return, and then the trustee of your bankruptcy will file a Form 1041 tax return. However, under Chapter 11, you have to file both your individual return as well as your Form 1041 bankruptcy estate return, as you typically are the trustee of the estate. Similar to the others, under Chapter 13, you will file the 1040 and the trustee will file a Form 1041 for each year of the bankruptcy.
These two separate filings are in your interest. They separate the debt that you owe and put that into one estate, leaving your other income and assets in another. Then, when you file your personal tax return, any refund goes to you rather than the estate. The refund for your bankruptcy estate’s return goes to paying off the debt.
It is essential that you pay off your tax liability while you are in bankruptcy. One of the major criteria for bankruptcy is that you are not allowed to accrue any additional debt. In some cases, any tax debt might fall under this category and lead to your bankruptcy being converted or dismissed. There is no protection to this debt because it was not part of your initial filing. This is especially key for those under Chapter 13 or Chapter 11 bankruptcy. These tend to stretch over multiple years, and if any new debt arises might be converted to Chapter 7, or in the worst case dismissed. Those already in Chapter 7 bankruptcy will not see any impact on their bankruptcy from not filing taxes in future years, but will still feel the financial impact of this new debt, especially as you are not allowed to file again until seven years has passed.
It is best for those in bankruptcy to seek the assistance of tax professionals to ensure their taxes are handled appropriately during and after their bankruptcy.
What Happens to Your Tax Refund During Bankruptcy?
It is important to recognize how your tax refund will affect your bankruptcy. Under Chapter 7 bankruptcy, your assets become part of the estate. This includes your tax refund. After the completion of your bankruptcy, any new assets, including a refund, is yours alone. However, because the tax refund involves a period of time prior to filing for bankruptcy and after, it becomes more complicated.
A trustee will typically take any unspent tax refund that occurs the year prior to your bankruptcy to help pay your debt. The trustees tend to see it as similar to any cash assets, since it is technically your money that was just sent in excess to the IRS. During the year of your bankruptcy, you will most likely be able to keep at least part of any refund. Typically, it is calculated by separating the income from before and after your bankruptcy, with you getting anything from after. Once you have completed your Chapter 7 bankruptcy, then any future tax refunds will go to you.
Because of this, some people will try to coordinate when they file for bankruptcy in a way that provides them with the ability to get the maximum amount of their tax refund. If you receive the tax refund while you are in the midst of filing for bankruptcy, you do not want to apply it to any of the debt, as it might alter your case. Do not use it to repay friends or family members either. This action might end up being considered a preferential payment. To keep it completely out of the hands of the trustee, spend it. However, do not spend it on frivolous or luxury items, as this could hurt you under what is known as bad faith. Instead, use it for necessary expenses, such as food, utilities, mortgage or rent payment, home repair, clothing, car payments, education, or medical care. Talk with your bankruptcy lawyer about it to determine the best course of action.
Under Chapter 13 bankruptcy, your trustee has the right to take your tax refund. As part of their role of trustees, they are allowed to take any disposable income to pay off the remaining part of your debt. For most trustees, a tax refund is typically considered disposable income. However, you might be able to request for the tax refund, such as if you have a special circumstance under which you need that money.
Can Your Federal Tax Debt Be Discharged With Bankruptcy?
As detailed in a previous post, under some circumstances, bankruptcy will discharge your federal tax debt. While you file for bankruptcy, it will stop any collection action, as long as the IRS has not filed a Relief of Stay. Your 10-year statute of limitations does extend over the period of your bankruptcy, in addition to a 30-day administrative time. You have to also have filed tax returns for the years in which you plan to have the debt discharged from bankruptcy.
Under Chapter 7 bankruptcy, you might be able to have your federal tax debt discharged along with your other debt. However, you must meet certain criteria, including:
- The tax liability is more than three years old
- The debt comes from income tax
- You have not conducted any tax fraud or evasion
- You are compliant with your tax returns and current tax liability and have been for the past two years
- The IRS has assessed your taxes under the 24-day rule
Under other types of bankruptcy, you will typically not be able to discharge your federal tax debt, although in some circumstances it might be possible under Chapter 13 bankruptcy. This will need to be discussed with your bankruptcy attorney. Upon completion of the payments agreed upon under Chapter 11 and 13, any other approved tax debt might be dismissed, but this is considered on a case-by-case basis.
Bankruptcy provides a beneficial way to get out of debt for a lot of people. However, if the main type of debt you owe comes from federal income taxes, then it might not be the right solution for you. There is no guarantee that the debt will be discharged, and it comes with a hefty negative impact on your credit. The IRS offers programs to help you get rid of your tax debt, such as an Offer in Compromise and an Installment Plan. At Fidelity Tax Relief, we are here to help you discover the right course of action for your federal tax debt.