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10 Things Tax Professionals Need To Know About Bankruptcy

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accountant-flickr-charlywkarlTax season approaches.

Tax preparers stand a good chance of encountering clients who either have filed bankruptcy, or who may benefit from a bankruptcy filing.

Here’s my list of bankruptcy nuggets that a good tax professional should have at hand.

Debts discharged in bankruptcy don’t trigger cancellation of debt income–

One of bankruptcy’s compelling features is that the debts cancelled by reason of the bankruptcy discharge don’t get included in the debtor’s income.  Bankruptcy, found in Title 11 of the U.S. Code, is the first exception on Form 982 to inclusion of forgiven debt in gross income.

IRS and state tax entities subject to the automatic stay  

A bankruptcy filing enjoins tax authorities from continuing collection action.  Thus the stay terminates garnishments and prohibits levies of the debtor’s assets.  It doesn’t, however, prohibit tax audits.

Bankruptcy can discharge income tax debt three years after return due

Taxes can be wiped out in bankruptcy if the return was due, including extensions, three years  or more before the bankruptcy is filed; any late filed return has been on file for 2 years; and the taxes were assessed more than 240 days before the commencement of the case.  More on overview of taxes in bankruptcy.

Chapter 13 is a quick and certain alternative to an OIC–

A  Chapter 13 plan is confirmed within weeks and binds the IRS just like any other creditor. The case discharges for all time the scheduled taxes, penalties and interest upon plan completion.  The plan must pay the priority taxes (those tied to returns less than three years old) and the interest on the priority tax as of the filing.  No new interest or penalties accrue during the pendency of the case.

Tax penalties are dischargeable

Penalties associated with dischargeable taxes are dischargeable;  all penalties are dischargeable in Chapter 13, and penalties associated with events more than three years past are dischargeable in Chapter 7 even if the tax isn’t dischargeable.

Chapter  7 estate, but not 13 estate, is a separate taxpayer

A bankruptcy estate owes the feds a return, and perhaps tax on capital gains it realizes by reason of sale or foreclosure.   Property remains property of the bankruptcy estate until the estate is closed or the property abandoned.

Tax attributes of the debtor pass to the bankruptcy estate  

The debtor’s basis, loss carry forwards, and exclusions are available to the Chapter 7 trustee, and  unused NOL’s revert to the debtor when the bankruptcy estate closes.

Debtor can elect short tax year for the year bankruptcy is filed  

A short year election can make tax attributes available to the debtor when he files the return for the pre bankruptcy portion of the year.  It can also quantify any tax due in the year of filing so that it is a priority claim for payment from the assets to be distributed in the bankruptcy case.

Tax liens generally survive the bankruptcy case

While lien survive as a charge on the assets the debtor owned at the filing of the case, the lien does not attach to assets the debtor acquires after the case is filed.  In Chapter 13, the lien need be paid only to the extent of the actual value of the assets subject to the lien.

Allowable deductions may be found in payments made on debtor’s behalf by Chapter 13 trustee

Chapter 13 plans often pay over time mortgage interest arrears  on the debtor’s home.  State taxes paid through the plan or business expenses including taxes may be deductions the Chapter 13 debtor can claim.

The rules covering federal taxes in bankruptcy are found in Pub. 902.  State taxes are subject to the same treatment in bankruptcy as federal taxes.

For more

For help with strategic use of bankruptcy to solve tax problems, look for a certified bankruptcy specialist in your community.

Some state bar associations and the American Board of Certification  certify lawyers who are specialists in bankruptcy.  Find California bankruptcy specialists by county.

Image courtesy of Flickr and CharlywKarl

Don’t File Bankruptcy In December

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wait to file bankruptcyBankruptcy can provide tax relief,  if your timing is right.

File bankruptcy before the end of the year and you fix only a part of your tax problems.  Any taxes for the current year aren’t part of the bankruptcy.

Tax troubles are at the heart of so many bankruptcy filings.  It makes sense:  bankruptcy is a powerful and predictable tool to get out of tax debt.

Yet I’ve been telling clients for weeks now:  don’t file bankruptcy…..yet.

Wait til January.

Why wait to discharge taxes

Because most people who owe back taxes are facing similar trouble for the current tax year.

Come the end of this tax year on December 31st, they’ll owe taxes for 2019 because their withholding doesn’t match the taxes due in April, 2020.

In Chapter 13, which is almost always the better chapter for tax troubles, the Chapter 13 plan doesn’t address tax years that aren’t closed when the case is filed.

That means that your liability for the year in which you file bankruptcy doesn’t get priority for payment over your credit card debts.  In fact, the open tax year often can’t be paid through the plan.

And I hate to see money go to general unsecured creditors when tax debt remains.

So, I’m counseling clients to wait til January to file.  Get this current year’s tax troubles rounded up and corralled in the Chapter 13.

Buy yourself 5 years to pay whatever you owe for this year along with the taxes that brought you in my door in the first place.

Tax liens in bankruptcy

Another one of Chapter 13’s superpowers is the ability to cut tax liens down to size.

No matter how huge the tax liens are, in Chapter 13 those liens get paid only the value of your possessions when you file your case.

Really, the liens get paid only the equity in your assets that remains after liens that were filed before the tax lien.

So even if the tax lien is $100,000, if the equity in your possessions is only $10,000, that’s what you pay over the 5 years of the plan.

And after the case is  over, the balance of the lien is voided along with the tax liability that it secured.

Pretty neat, eh?

When IRS threatens to levy

A notice of intent to levy is often what makes folks call up a bankruptcy lawyer.  That notice seems to promise doom and the end of life as you know it.

Know that an actual levy is the IRS’s last resort.  There are processes and procedures built into the Service’s collection process.

A levy gets only what’s in the levied bank account on the day the levy is served.  If the bank balance is tiny, the IRS’s recovery is tiny.

Usually, if you engage the IRS in discussions about a payment plan, or even make a payment on your debt, your case becomes a lower priority for an understaffed IRS.

It depends on the numbers, of course, but usually, the advantages to waiting til January 1 outweigh the risk of collection between now and then.

Once your case is filed, the IRS, along with every other creditor, is forbidden to continue collection action.

Before you file bankruptcy

There’s lots to do to prepare for a bankruptcy filing.  These weeks won’t be wasted.

Why your bankruptcy papers are critical

Your bankruptcy attorney will need lots of paper from you to get your schedules right and to calculate a plan to get you out of debt.

Some of the things you’re likely to need include:

  • Pay stubs for the past six months, including December’s
  • Tax return
  • Contract for any financed vehicles
  • Tax notices from federal and state
  • Appraisal or broker’s opinion on the value of your real estate
  • Proof that your retirement accounts are exempt
  • Bank and investment account statements

You also need to prepare to get your tax return for this year filed quickly after your bankruptcy is filed.  You have 45 days from the filing of your Chapter 13 to get the return filed.  So start gathering whatever you’ll need to get the return on file promptly after your bankruptcy case is filed.

And, readjust your withholding for next year so you are adequately withheld for the coming year.  Owing more taxes once you are in bankruptcy is grounds for the dismissal of your case.

Find a good bankruptcy lawyer

Bankruptcy is difficult enough.  You need to have confidence and rapport with your bankruptcy lawyer.

Use the time between now and the first of the year to interview a bankruptcy lawyer and find one with experience in tax matters.

How to interview a bankruptcy lawyer

It’s equally important to find a lawyer to whom you are willing to confide your secrets and your worries.  The problem I can’t protect you from is the one you don’t tell me about.

So when you hear those screeching commercials that say “don’t file bankruptcy”, you can add, “yet”.

File bankruptcy at the right time for the right reason.

Bankruptcy Busts Taxes If The Timing Is Right

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taxes dischargeable

Got unpaid taxes for 2015?  Three tax discharge timing rules control when those taxes can be wiped out in bankruptcy.

On April 15, 2019  those taxes reached the end of the line as priority claims in bankruptcy.  Or, the magic date may be October 15, 2019, if you got an extension to file the return.

As non-priority claims, the taxes lose their protected status and can be discharged in bankruptcy.

Discharged, as in, no longer a personal liability.  No longer entitling the IRS to levy and garnish because of a bankruptcy discharge.

Taxes are collectible for 10 years from assessment, outside of bankruptcy.

That’s the view from 30,000 feet on discharging taxes in bankruptcy.  Let’s look at the details and see why  April 15th  is important if you have old taxes you haven’t paid.

Three year rules to discharge taxes

To wipe out taxes in bankruptcy, three rules control.

The first one, the “three year rule”, says taxes can’t be discharged until three years have passed since the tax return was last due.

Taxes newer than that are priority claims.  Priority tax claims aren’t dischargeable.

There are a couple of wrinkles in the three year rule.

First, the rule starts running from the day on which the tax return was last due without penalty.  Without an extension of time to file, that’s usually April 15th.

So, the return for 2015 was due April 15, 2016.  You start counting from then.

Unless you got an an extension, 2014 taxes became dischargeable in bankruptcy on April 16 of this year.

Filing your tax return before the deadline doesn’t get you a head start on the three year rule.

Even if you got an extension and actually filed your return in June, the controlling rule still starts counting from the last day on which you could have filed the return:  October 15th.

Two year rule

The second rule governing the discharge of taxes is the “two year rule”.

The “two year rule” says that if the tax return wasn’t filed on time, it has to have been on file for at least two years to be discharged in bankruptcy.

So, even taxes where the three year rule is met don’t go away in bankruptcy if the return was late and hasn’t been on file for two years.

Recent assessment rule

The third rule, the “240 day rule”,  says that taxes assessed within 240 days of the bankruptcy filing aren’t discharged, even if the other two rules are met.

Tax year must be closed

There’s an additional strategic issue involving taxes and bankruptcy in Chapter 13.  A Chapter 13 plan can provide for payment of taxes  that aren’t dischargeable through the Chapter 13 plan.

But, BUT, the tax year must be complete in order to include the tax in the payment plan.  So, if you file in October, 2019 to discharge 2015 taxes, any tax you may owe for 2019 won’t be included in the bankruptcy case.

Depending on the amount you expect to owe for this year, you may be well advised to wait til January 2, 2020 to file your bankruptcy case.

The important point is well-advised.  Discharging taxes in bankruptcy is highly detailed.  Get good advice from an experienced bankruptcy attorney.

More about taxes in bankruptcy

Tax liens after bankruptcy

What about unfiled tax returns

Chapter 13 is a tax tool

 

Image copyright Fotolia.

Stop Making Quarterly Tax Payments

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quarterly tax paymentUncle Sam expects a quarterly tax payment from the self employed.  Since you don’t get a paycheck with regular tax withholding, the burden’s on you.

Lighten the burden. Make this the last quarterly tax payment you pay.

Seriously.  Don’t make any quarterly payments for this coming year.

Think I’m advocating tax resistance?  No way.

The tax collectors  have more weapons than you want to encounter.  It’s like the advice from the era of newspapers:  don’t pick a fight with someone who buys ink by the barrel;  

Don’t spit in the face of the tax man.

Give up making them quarterly, I say.

Pay taxes monthly, just like every other recurring bill in your life.

Why quarterly tax payments invite trouble

Folks who get a paycheck have their income tax liability, or at least some estimate of that liability, deducted from each paycheck.  No fuss, and, well,  only some bother.

Their take home pay has already paid the taxes.  The paycheck is what is available to pay the bills.

Not so the self employed.

We are expected to make quarterly estimated tax payments in January, April, July, and October.

I’m sure the quarterly arrangement was seen as a convenience when instituted.

But it’s not necessarily convenient.  You have to set aside money regularly so you have a fistful come quarter day.

If you free lance or run a small business, budgeting may be the hardest think you do.  Who knows, in this economy, how much you’ll make this quarter, or how you’re going to pay the bills?

Quarterly payments invite us to fudge.

Get caught not having prepaid enough and you get  hit with penalties.

Get really behind, and it’s tax liens and levies.

Pay this year’s taxes monthly

My charge?  Add Uncle Sam to your list of creditors that you pay monthly.

Most creditors expect monthly payment:  the rent, the car payment, the credit card.  Add your estimated taxes to that list.

Income taxes are a cost of doing business.  No reason not to pay them as you go, just like the folks on salary do.

  • You avoid the need to set up a separate savings account in which to accumulate the taxes to be paid quarterly.
  • You resist the temptation to use those savings for some intervening crisis.
  • You escape the urge to make no provision “just this month”.

Making regular and smaller payments makes it easier to get the total bill paid in a manner that avoids penalties for not paying regularly.

Send your monthly income tax prepayment to the same place the quarterlies were headed.  Write on your check your Social Security number and “estimated 2017  tax liability”.

Take care of taxes monthly and you don’t find yourself in a tax hole come next April.

Here’s the IRS  on making estimated tax payments.

More on taxes

Unfiled taxes live forever

Dig out of payroll tax trouble

  Getting rid of tax liens

Find the mortgage interest deduction in Chapter 13

Image courtesy of Wikimedia.

Tax Deductions Hidden In Chapter 13

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taxesDon’t miss the tax deductions hiding in your Chapter 13 plan payments.

The same, very important debts that your Chapter 13 plan pays are often tax deductible.

And you are still the person who’s paying, even if the trustee writes the check.

Deductions in bankruptcy

Let’s look at some common deductions lurking in the Chapter 13 disbursements.

Mortgage interest  If your Chapter 13 plan is catching up on delinquent mortgage payments, the claim of the lender is probably mostly interest.

Taxes  Property taxes paid through the plan should be deductible.  Likewise, state income taxes paid by the trustee are deductible.

 Business expenses  If you operate a business in Chapter 13 or operated one before you filed, you may be paying business leases, sales taxes, or vendor debt through the plan.

Get the info you need

In my experience, you have to dig out the information on deductible payments;  I have not seen lenders sending 1098’s reporting mortgage interest paid to debtors when the checks come from the trustee.

Step by step to claiming the mortgage interest deduction

But most if not all Chapter 13 trustees are on the web, and debtors can access the trustees reports of which creditors have been paid this year.

Pull up the report of last year’s disbursements and flag the payments that are deductible.

Save the printout of the trustee’s report in case of question  by the taxing authority.  The IRS will not have gotten a matching report from the lender who got the money and hasn’t reported it to you and the IRS.

How to treat 1099’s on foreclosures and short sales

Go back to prior tax years

If your plan is paying deductible expenses and you’ve been in the bankruptcy case for several years, you may want to look at prior year trustee reports.  Overlooked deductions might justify going back to amend a prior return.

Tax returns are generally amendable for three years.

Check it out

Take this post with a grain of salt, or rather, take it to a tax professional.

I am a bankruptcy lawyer and what I know about taxes, I’ve learned on the job.  But I am convinced that Chapter 13 debtors are missing legitimate tax deductions by overlooking what the Chapter 13 trustee has paid on their behalf.

What your tax professional should know about tax and bankruptcy

Image courtesy of 401(k)calculator.org

Bankruptcy Discharge Slays IRS Form 1099

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In a duel between a Form 1099 and a bankruptcy discharge, bankruptcy wins every time.

The prize?  no tax on debt discharged in bankruptcy.

So, if you’ve already gotten your discharge, the creditor’s 1099, with your social security number on it, is no threat.

But you do need to file another form to secure the prize.

Bankruptcy is exception to tax

Normally, when an obligation is forgiven, the tax code treats the amount of forgiveness as if it were income.  And income is exposed to tax.

Insolvency is another exception to tax on forgiven debt

But forgiveness in bankruptcy in the first exception to the rule.

Debt forgiven in bankruptcy is not treated as income.

Creditor is clueless

So, if bankruptcy is outside the IRS rule, why are you getting a form 1099?

Because there’s another rule, requiring creditors to report to the IRS, just the way your employer is required to send the IRS your W-2.

And seemingly, the creditor can’t figure out that the reason its claim is worthless is because of the bankruptcy discharge.  So it’s easier for the creditor to just send out Form 1099, and make it your problem.

Fixing the 1099 problem

The solution is simple:  file IRS form 982.

Title 11 is the part of the United States Code on bankruptcy.  Cases are filed under different chapters of that title

Form 982 is your rebuttal to the report that you have taxable income because your debt was forgiven.  Check the very first box on the form claiming the bankruptcy exception.

This debt is excluded from income because of  Discharge of indebtedness in a title 11 case 

The IRS provides a set of instructions for filing  your “get out of tax” form.  Form  982 Instructions.

Other tax consequences of discharge

If you have real property, you may have to reduce your basis in assets by the amount of debt discharged in your bankruptcy.

But thankfully, there is an exception to this rule too:  no reduction in basis is required with respect to your principal residence claimed exempt in your bankruptcy case.  IRC 1017(c).

Tax action plan

So there you have the skinny on form 1099 and your bankruptcy discharge.

Bankruptcy has other tax implications:

Taxes dischargeable in bankruptcy

Unfiled tax years are never dischargeable

Chapter 13 gets an interest-free tax repayment plan

Your accountant needs to know about your bankruptcy

What to do with a flat-wrong 1099

 

Five Tax Tips For Two Cents

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8328967338_37e260ff6b_h_optThe tax filing deadline approaches.

So why is a bankruptcy lawyer talking about taxes?

I’ve found over three decades as a bankruptcy lawyer that there’s a surprising degree of overlap between bankruptcy and tax .

All too often, it’s tax troubles that brings a family to me for help.

Here’s my two cents on what I know about taxes.  It’s not a lot, but what I know is both simple and critical.

File those tax returns

Lots of folks who end up in my office discussing bankruptcy held off filing their returns because they figured they couldn’t pay the tax that would be due.

Bad decision.

Without a return, taxes never die

The IRS will not descend on you the week after you file a return with tax due but no check.  They’re still opening envelops.

But filing a return gets all kinds of time periods running that may benefit you:  the 3 years til the taxes are dischargeable in bankruptcy;  the 10 years til the tax collection statute runs.

Whatever you do, don’t let the IRS file a tax return for you.

Don’t pay tax on discharged debt

If your debts were discharged in bankruptcy last year, that discharge has no tax consequences.

The Internal Revenue Code specifically excludes from taxable income any debts forgiven in bankruptcy.

Cancellation of debt is tax free

You may get a 1099 reporting the cancelled debt.  The creditor whose debt is forgiven is required to do so.

It’s up to you to assert that there’s an exception to tax.  And there’s an IRS form to rebut any tax consequences.  Get it and file it.

Claim deductions for Chapter 13 payments

If you’re in a Chapter 13 that catches up arrearages on real property loans, claim those payments as deductions of your own.  Just because the trustee writes the check, it’s still you paying the mortgage interest in that payment.

How to find and claim the deduction

The concept here goes beyond mortgage interest.  If the expense was deductible had you written the check, it’s deductible if the trustee pays it.

Get the trustee’s disbursement records in your case from  the trustee’s web site and get to deducting.

If you owe tax, fix your withholding

The return to be filed this spring can tell you if you are withholding enough money to pay your taxes.

If there’s a big number on the bottom line of the return for last year, and this year looks similar, increase your withholding now.

What Goldilocks knew about taxes

And if you think you can’t pay taxes as you go and support the rest of your living expenses, you need to look hard at the big picture.

It’s generally a poor decision to short the feds so you can pay AmEx or Visa.

Amend old returns if you missed something

If you missed a deduction or otherwise overpaid your taxes in a previous year, you have only three years to amend that return and claim a refund.

Time running out to claim prior year tax breaks

Lower income families often miss the fact that they get a tax credit (that’s real money, not just a deduction) under the Earned Income Tax Credit.  Find out if you are eligible.

More

Discharging taxes in bankruptcy

The tax filing extension can be dangerous

Wiping out tax liens

How Consumer Remedies Were Gutted By Little- Noticed Tax Code Changes

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Tax code changes effective in 2018 inflicted a crippling blow to consumers who must sue to enforce their rights.  And few have yet noticed.

The tax deduction for miscellaneous itemized deductions under IRC Section 212 is gone. So now, consumers who prevail under statutes that award attorneys fees to the successful plaintiff are denied a deduction for the legal expense of winning that victory.

The income is taxed but the cost of producing that income is no longer deductible.

So, a large hunk of a consumer’s recovery goes, not to the injured consumer, but to the IRS.  Or even, all of a consumer’s judgment is consumed by taxes.

What happened to consumer litigants

IRC Section 212  has long allowed individuals to deduct the ordinary and necessary expenses incurred to produce income. At least partially.

That is, until the Tax Cuts and Jobs Act, passed December, 2017, including this zinger:

Notwithstanding subsection (a), no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.  Section 67(g)

So the deduction for the expense of producing income as a miscellaneous itemized deduction for individual tax payers vanished.  Poof.

The rational for its removal sounds great:

“Not that many taxpayers itemize their deductions so the deduction(s) won’t be missed.”

And thus, a bedrock principle of taxation, that the expenses of producing that income is deductible before tax is imposed, was cast aside.  With dire consequences for consumer rights, whether intended or not.

Tax changes abound

Miscellaneous itemized deductions weren’t the only victims of the 2017 tax act. HUGE things happened in the world of taxation on Jan  1, 2018 when the tax bill became effective.

For good or ill, perhaps wholly or partially dependent on your politics, the practical world of untold millions of individual taxpayers changed radically.

  • What would be alimony and heretofore deductible isn’t. (At least for most January 1, 2018 divorces.)
  • One very important protection afforded for debt relief from the disposition of a personal residence lapsed and has not been resuscitated.

There are many others.

But the devastation inflicted by Section 67(g) was initially far from obvious. It typically doesn’t become clear  until it’s time to file a federal tax return.

What had been a longtime method for getting at least some deduction for real expenses is gone.

Gone…

But thereby hangs a tale. Most taxpayers don’t itemize UNTIL THEY NEED TO DO SO. Now they can’t. Not even a little. And it gets much worse.

The power to tax….

The deduction allowed by  under IRC 212 prior to 2018 was already a ludicrously constructed monkey-motion system.  Lawsuit recoveries are typically reportable to the recipient in the GROSS recovery amount without diminution for attorneys’ fees payable to the attorney(s) whose services were indispensable in creating the income,

In order to get any deduction for attorneys fees paid, IRC Section 67 mandated:

The miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income.

This calculation often results in a sizeable bite coming out of the deduction the hapless taxpayer ultimately gets to take.

Now after Jan. 1, 2018, there is no deduction at all.

Picture the average non-itemizing single parent taxpayer suing for wrongful termination under this new tax regime.

  • The legal pushback from the errant employer is fierce and attorneys’ fees on both sides are high.
  • The settlement calls for $500,000 to be paid to the plaintiff .and,
  •  40% of the recovery goes to the plaintiff’s attorney as fees.

In the typical course of things post Jan 1, 2018, the plaintiff will be taxed on the FULL $500,000 recovery. Plaintiff gets NO deduction for the $200,000 in attorneys’ fees paid. None…

The plaintiff walks away (limps away actually) having paid taxes on AT LEAST $500,000 of income out of the $300,000 of money they actually net. (Yes, the attorney then pays tax on the $200,000 already included in the plaintiff’s income.)

Kinda discourages injured individuals from using consumer protection laws to protect themselves, doesn’t it?

Statutory penalties without deduction

If you perhaps think this isn’t so bad, picture the many hundreds of thousands of suits brought where the plaintiff is entitled to a fixed fee, fine or other relatively low statutory amount.

The purpose of these consumer lawsuits is to promote regulation of activities like as an example, lending-related abuses. In these cases the state consumer laws providing for the suits often allow the attorneys for the plaintiff to collect their fees from the lender or other business.

These suits now regularly result in the plaintiff being in deep debt to the IRS with insufficient funds to pay even the tax. AKA: Tax Hell.

Without direct decisive legislative change this horrendous damage will play out across the country for years.

It will continue until the right people suffer from its effects. Only then will there be any change(s).

 

 

 

The Tax Deduction No One Tells You About

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Money on the tableDid you file Chapter 13 to save your house from foreclosure?

Making payments to the trustee to catch up on the mortgage?

If you haven’t claimed a tax deduction for the bankruptcy plan payments that go to the lender, you’re leaving money on the table.

That’s money that fattens Uncle Sam’s coffers at the expense of your own.

You don’t really want to do that, do you?

Mortgage interest deduction

If your Chapter 13 plan is getting you current on your home mortgage, the plan is funneling a part of each month’s Chapter 13 payment to the lender.

Missed mortgage payment are largely interest, unless you are years in to a fully amortized loan.  So when your Chapter 13 plan proposes to get current on the loan through payments to the Chapter 13 plan, you’re proposing to pay the interest due.

The tax benefit in homeownership revolves around the fact that mortgage interest is deductible if you itemize your deductions.  Interest paid reduces the income on which you pay tax.

And, you don’t forfeit that tax benefit when you file Chapter 13.

Yet, for reasons I cannot explain, mortgage lenders seem to have gotten a pass on the reporting requirements that govern non bankruptcy payment of interest.  They don’t report to the IRS and to you, the ultimate payor, the interest paid through the bankruptcy plan by means of a 1098 form.

Find the deductible interest

To claim your deduction, you’ll have to dig a bit.  All Chapter 13 trustees now have websites where you can access a report about distributions made to creditors by the trustee.

You may have to figure out whether the proof of claim for the mortgage loan was filed by the original lender or by the servicer, or sometimes by the trustee of the Wall Street trust that owns the note.

Step by step instructions to calculate mortgage interest paid by the trustee

The claim usually stands out because it will include the total balance owed on the loan.

Buried in that mass of numbers will be the amount paid to the mortgage lender.

Make sure to print out the reports that show the amount.  Since the IRS didn’t get a copy of a 1098 showing payment of mortgage interest from the lender, you may have to back it up from your files.

Deadline to amend back returns looms

If you’ve been in your plan for several years, think not just about the return due soon.  Consider amending earlier returns to claim the deduction, and get a refund of what you overpaid in taxes.

You get three years from when you filed the tax return to amend it.  The IRS has a handy, dandy fact sheet on amending returns.

Don’t leave your money on the table for Uncle Sam.  Claim that deduction.

Image courtesy of Flickr and TracyO

How Guarantors Can Escape Tax On Soured Debt

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Tax lawyer Bill Purdy and I shared a client with a small interest in a failed corporation with a huge SBA loan.  Could our client escape the tax consequences should we be able to settle his  liability on a million dollars in unpaid loan.  Was the client looking at a million dollars of cancellation of debt income? Here’s the marvelous result that Bill’s caper through the IRS regs returned.  Cathy

Ever guarantee the debt of another? Ever meet anyone who has?

Chances are if you’re in business and the business is a C-corporation, an S-corporation, an LLC , or a partnership, when that business borrows money, the lender will require one or more persons who own/control the entity to personally guarantee the business debt.

It seems harmless at the time. But signing a personal guarantee is as serious as a heart attack.

It can feel just like one if the lender tags you to actually pay the debt. Institutional lenders including but certainly not limited to, the SBA, don’t hesitate to demand payment from guarantors when the actual debtor fails to pay.

When regulations are your friend

Against this backdrop Treasury Regulation §1.6050P-1(d)(7) might take your breath away:

Guarantors and sureties. Solely for purposes of the reporting requirements of this section, a guarantor is not a debtor. Thus, in the case of guaranteed indebtedness, reporting under this section is not required with respect to a guarantor, whether or not there has been a default and demand for payment made upon the guarantor.

Did I read that right?

The regulation just cited is the official US Treasury guide for issuing (or NOT issuing) Form 1099-C when a debt is settled for less than the amount owed.  And that’s critically important since the usual consequence of a 1099-C is the inclusion of that amount in taxable income.

The regulation’s language is careful to limit its reach solely to the issue of whether or not a Form 1099-C should be issued.

But unlike so many other regulations and provisions of the Internal Revenue Code, it is NOT followed by endless provisos, exceptions and intricacies.

A lender who settles a debt for less than face is not supposed to issue a Form 1099-C to a guarantor because none is required. It doesn’t matter if the debt was settled with the actual debtor or if the lender demanded payment from the guarantor upon default by the debtor.

Given that reporting financial institutions are

  • responsible for issuing Form 1099-C in a timely and accurate fashion,
  • often fail to do so correctly and
  • face no consequences if they don’t,

this is potentially a very important rule to know.

What is much more important is to know why.

Love letter from the IRS

The “why” is found in Internal Revenue Service INFO 2002-0024 (released 3/29/2002).

In it, the IRS flatly states that a guarantor is not debtor who recognizes Form 1099-C debt relief, whether or not the creditor formally looks to guarantor for payment or settles with the actual debtor.

Once again the Service’s conclusion is sweeping and admitting of very little wiggle room ( which is hardly characteristic of that organization).

Unlike many attorneys and some court cases, the IRS DOES NOT ground its statement in the warm and fuzzy idea that the taxpayer received nothing of value in the way of loan proceeds or other benefits at the inception of the loan.

Instead, the Service bases its position on the idea that what the guarantor potentially gives (pays) is the basis for exclusion from debt relief.

This conclusion rests squarely on statutory law. IRC 108(e)(2).

Where payment by the guarantor would have given rise to either a business bad debt deduction or a capital loss deduction, the Service blesses the guarantor with an exemption from taxable debt relief.

Full stop. End of story.

Escape hatch for homeowners, too

homeowner taxOrdinary homeowners who receive Form 1099-C(s) are supposed to get the benefit of Section 108(e) (2) as well.

Any interest forgiven by lenders which would otherwise be deductible if paid by the homeowner are supposed to be removed from the calculation of taxable debt relief on the Form 1099-C.

Indeed the interest amount is supposed to be separately stated on that form in Box 3.

Given the massive number of defaulted loans with accrued interest, and negatively amortized loans that were “modified” with the accrued unpaid interest added to principal to make a “new modified principal balance” your guess is as good as mine as to whether lenders handily disguised hundreds of billions in interest income by transmuting it to “principal” on which they NEVER paid taxes.

There is little doubt this accrued interest was not correctly removed from modified debts when Form 1099-C(s) were issued on foreclosure or short sale.

Down the rabbit hole

And then, there’s Bullock.

A tax court, no less, held held that the taxpayer who actually signed a direct promise to pay as debtor did not incur a bona fide debt and was actually a guarantor. Bullock TC Memo, 2017-219.

One would assume the IRS was less than amused by the result in this case.

The judge actually references the idea that there was no net accretion of wealth to the taxpayer and then likens her situation to that of a homeowner where a tornado misses the home and thus she has no real net economic benefit.

Eh? Gadzooks!

Please don’t rely on Bullock as authority for the idea that a guarantor is not a debtor and thus no form 1099-C should be issued. Here the Tax Court emptied the baby’s bathwater out on the courtroom floor and started over.

Then much hemming and hawing ensued with citations to Dixie Dairies Corp. v. Commissioner, 74 T.C. at 494 and the existence of no bona fide debtor creditor relationship. (Sharp intake of breath…) Bullock manufactures a de-facto guarantor out of what was clearly direct debtor paperwork signed by the taxpayer, a high risk legal result at best.

Walk the Walk

The Bullock court may have felt great deciding as it did, but don’t count on any court to decide no real debt existed where your client signs on as a named debtor.

Especially here in California with some of the most obsequious and deferential judges alive when it comes to supporting lenders and the financial industry.

To get the one of the very few benefits of being a guarantor for tax purposes, be a guarantor in writing and in fact.

More Bill

When the 1099 is wrong

Danger in the long silent second mortgage

6 rotten reasons not to file bankruptcy

 

Guest author Bill Purdy is a tax and real estate lawyer with Simmons and Purdy in Soquel, California. I’m always tickled to share Bill’s pointed perspective on places our practices overlap.

          Bill and his partner Pam Simmons are my go-to resource for all matters of tax and mortgage law.  Bill assists clients with outstanding federal and state income tax liabilities, Form 1099-A and 1099-C related issues, collection resolution, failure to file returns and employment tax related liabilities. 

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