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10 Things Tax Professionals Need To Know About Bankruptcy

By Cathy Moran

accountant-flickr-charlywkarl

Tax 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.

Table of Contents

  • Debts discharged in bankruptcy don’t trigger cancellation of debt income–
  • IRS and state tax entities subject to the automatic stay  
  • Bankruptcy can discharge income tax debt three years after return due
  • Chapter 13 is a quick and certain alternative to an OIC–
  • Tax penalties are dischargeable
  • Chapter  7 estate, but not 13 estate, is a separate taxpayer
  • Tax attributes of the debtor pass to the bankruptcy estate  
  • Debtor can elect short tax year for the year bankruptcy is filed  
  • Tax liens generally survive the bankruptcy case
  • Allowable deductions may be found in payments made on debtor’s behalf by Chapter 13 trustee
  • For more

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

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Filed Under: Featured, Taxes Tagged With: accountants, tax preparers

About Cathy Moran

I'm a veteran bankruptcy lawyer and consumer advocate in California's Silicon Valley. I write, teach, and speak in the hopes of expanding understanding of how bankruptcy can make life better in a family's future.

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About The Soapbox

You've arrived at the Bankruptcy Soapbox, a resource of bankruptcy information and consumer law.

Soapbox is a companion site to Bankruptcy in Brief, where I try to be largely explanatory and even handed (Note I said "try").

Here, I allow myself to tell stories and express strong opinions on how I think law should work for the consumer and small businesses when it comes to debt.

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