Just about anything you do potentially has tax consequences, and bankruptcy is no exception. Each bankruptcy type has its own affect on taxes in ways you may not realize.
One benefit of bankruptcy is that your discharged debt doesn't have any real impact on your taxes because it doesn't count as taxable income. However, you may not be able to take certain tax credits and deductions you might otherwise be able to if you didn't file.
Knowing the tax consequences of bankruptcy before filing will help you decide if bankruptcy is right for you.
Separate Taxable Estates
Filing for Chapter 7 bankruptcy creates two separate estates: Your individual estate and the bankruptcy estate. If you and your spouse file a joint bankruptcy petition, the new estates are both handled by a trustee. Each estate is treated separately for tax purposes.
Chapter 13 doesn't create a separate taxable bankruptcy estate. You'll file a tax return just like normal.
Responsibilities of the Individual Chapter 7 Filer
You're still required to send an individual tax return to the IRS even if you declare Chapter 7 bankruptcy. However, you don't include income, deductions or credits that belong to the separate bankruptcy estate.
You can choose to end your tax year on the day before you file for bankruptcy. If there's any tax due at that time, it's treated as a claim against the bankruptcy estate. However, it's possible you may have to pay those taxes after you file. You must file another return for any income you earned during the rest of the year.
The Bankruptcy Estate
Trustees managing bankruptcy estates are responsible for preparing and filing the income tax return for those estates. At the close of the case, any remaining assets in the estate are returned to you, without any tax consequences.
Automatic Stay and Tax Assessments
An automatic stay goes into effect as soon as you file for bankruptcy. All collection efforts by creditors must stop, and all legal proceedings against you are suspended, including legal actions by the IRS. However, the automatic stay doesn't stop the IRS from:
- Auditing you
- Demanding you file tax returns
- Sending you a notice of tax deficiency
- Making tax assessments (setting the value of taxable property) and issuing of a notice and demand for payment of the assessments
Payment of Tax Claims
In a Chapter 7 bankruptcy, the IRS usually can't take your money or property to pay income taxes if those taxes became due within three years of the date you filed for bankruptcy. However, the IRS can file a proof of claim for those taxes. The claim is paid out of the assets of the bankruptcy estate if there's anything left after other creditors are paid.
Generally, tax claims older than three years old (from the date of your bankruptcy) may be removed in Chapter 7.
Under Chapter 13, you pay your unpaid income taxes over three or five years, based on your debt repayment schedule.
Reduction of Tax Attributes
If you excluded the amount of discharged debt from income, you must use that amount to reduce certain deductions and credits, called tax attributes. Generally, these attributes must be reduced in this order:
- Net operating losses
- General business credit carryovers
- Minimum tax credits
- Capital losses
- Basis of your property
- Passive activity loss and credit carryovers
- Foreign tax credit
If you filed under Chapter 7, the reduction of tax attributes is made on the bankruptcy estate's tax return. If you filed under Chapter 13, the reduction is made on your personal tax return.
Deciding whether or not to file for bankruptcy is a hard decision to begin with. Think about all the possible side effects, including how your taxes are impacted. If you have any questions, ask your attorney while you're discussing your options.
Questions for Your Attorney
- Do I have a choice between filing under Chapter 7 or 13? Which is best for me?
- Is a trustee appointed in every bankruptcy case?
- After I file bankruptcy, do I have to keep making payments under an installment payment plan I worked out with the IRS before I filed for bankruptcy?