As tax season approaches, tax pros need a basic understanding of bankruptcy to serve clients well.
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.
1. 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.
2. 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.
3. 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.
4. Chapter 13 can be 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.
5. 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.
6. 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.
7. 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.
8. 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.
9. 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.
10. Allowable deductions may be found in payments 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 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