Are Bankruptcy Payments Tax Deductible for Individuals and Businesses?
Understand how bankruptcy-related expenses are treated for tax purposes and learn key differences in deductions for individuals and businesses.
Bankruptcy can be a stressful and complicated process for both individuals and businesses. A common question is whether costs associated with bankruptcy are tax deductible. Understanding how these expenses interact with taxes can aid financial recovery.
This article explores potential deductions related to bankruptcy payments and costs, helping clarify the rules depending on your situation.
Deductible vs Non-Deductible Bankruptcy Costs
Generally, payments made to creditors under a bankruptcy plan, such as in a Chapter 13 repayment arrangement, are not tax deductible. These are typically viewed as repayments of existing debt principal, which does not qualify for a deduction.
However, certain costs incurred during the bankruptcy process itself, like legal and administrative fees, might be deductible. The key factor is the underlying reason for the bankruptcy, often referred to as the “origin-of-the-claim” doctrine.
If bankruptcy stems directly from debts related to operating a trade or business, the associated legal fees and administrative costs may be deductible as ordinary and necessary business expenses under Internal Revenue Code Section 162.1FindLaw. 26 U.S. Code § 162 – Trade or Business Expenses These expenses must be directly connected to the taxpayer’s profit-seeking activities, covering tasks like negotiating plans or reconciling claims. Such costs might qualify even if the business failed in a prior year.
Expenses related to bankruptcy arising from investment activities, rather than a trade or business, could potentially fall under Internal Revenue Code Section 212.2Legal Information Institute (Cornell Law School). 26 CFR § 1.212-1 – Nontrade or Nonbusiness Expenses This section covers expenses for producing or collecting income, or managing property held for producing income. These costs are typically treated differently than business expenses and may face limitations, particularly under recent tax law changes. Expenses tied to tax-exempt income are generally not deductible.3FindLaw. 26 U.S. Code § 265 – Expenses and Interest Relating to Tax-Exempt Income
Conversely, costs associated with personal bankruptcy, where debts are primarily non-business related (like consumer credit card debt or medical bills), are usually considered non-deductible personal expenses under Internal Revenue Code Section 262.4FindLaw. 26 U.S. Code § 262 – Personal, Living, and Family Expenses This includes legal fees for handling personal liabilities.
If a bankruptcy involves both business and personal debts, an allocation of the costs (legal fees, court costs, trustee fees) is necessary. Only the portion attributable to the business debts may be deductible.
While payments to creditors are usually not deductible, certain payments made through a bankruptcy plan might contain deductible elements. For example, if a Chapter 13 plan includes ongoing payments for mortgage interest or property taxes that are normally deductible, those specific portions may retain their deductibility. Similarly, payments for ongoing business expenses covered by the plan might be deductible.
Documentation for Potential Deductions
Maintaining thorough and organized records is essential when dealing with the tax implications of bankruptcy costs. The Internal Revenue Service (IRS) requires taxpayers to keep documentation supporting any deduction claimed.5Internal Revenue Service. Topic No. 305, Recordkeeping
For potentially deductible bankruptcy-related expenses, retain proof of payment and details about the nature of the expense. Useful documents include:
Invoices from attorneys and other professionals
Canceled checks
Bank or credit card statements
Court documents detailing fees or payments
These records must clearly show the amount, date, payee, and the specific service or cost.
Clear documentation is particularly important when costs relate to both business and personal matters. Request detailed invoices that separate charges for services related to deductible business debts from those for non-deductible personal liabilities. Without clear allocation, substantiating the deductible portion can be difficult if the IRS examines the return.
The IRS generally requires records supporting items on a tax return to be kept for at least three years from the filing date or due date, whichever is later.6Internal Revenue Service. Managing Your Tax Records However, longer periods apply in certain cases, such as underreported income (six years) or claims involving worthless securities or bad debt deductions (seven years). Retaining all relevant bankruptcy documentation for at least seven years after the relevant tax return is filed is a prudent approach. Records can be kept electronically or on paper, provided they are accessible and legible.
Impact on Personal vs Business Filers
The tax treatment of bankruptcy differs significantly based on the filer’s circumstances. For individuals filing personal bankruptcy (like Chapter 7 or 13) primarily due to consumer debt, the costs like attorney fees are generally non-deductible personal expenses.
For businesses filing bankruptcy (Chapter 11 or 7), or individuals whose debts stem mainly from business activities, the tax treatment changes. Legal and administrative fees connected to the business bankruptcy may be deductible business expenses if they are ordinary and necessary for the operation of the trade or business.
A notable difference arises in Chapter 7 or Chapter 11 individual bankruptcies. Filing creates a separate taxable entity: the bankruptcy estate. This estate controls the debtor’s non-exempt assets, reports income generated by those assets, and claims related deductions, including administrative expenses like attorney and trustee fees. The individual debtor files their own tax return but generally does not claim deductions belonging to the estate.
In contrast, under Chapter 12 (for family farmers/fishermen) and Chapter 13, a separate bankruptcy estate is not created for tax purposes. The individual continues to file their usual tax return, reporting all income and claiming allowable deductions as if bankruptcy had not occurred, though discharged debt is typically excluded from income.
Filing Steps for Claimed Deductions
Claiming deductions for bankruptcy-related costs requires specific reporting depending on the expense type and filer. Sole proprietors deducting costs originating from their trade or business generally report these expenses on Schedule C (Form 1040), Profit or Loss From Business.7Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss From Business
These costs, such as legal fees related to the business portion of the bankruptcy, must be ordinary and necessary expenses for carrying on the business. On Schedule C, legal and professional fees typically go on Line 17. Other costs might be listed in Part V, “Other Expenses.” Maintain meticulous records to substantiate these entries. IRS Publication 535, Business Expenses, offers general guidance.8Internal Revenue Service. About Publication 535, Business Expenses
If bankruptcy involves mixed business and personal debts, only the allocated business portion is deductible on Schedule C. The allocation must be reasonable and supported by documentation like detailed invoices.
In individual Chapter 7 or Chapter 11 cases, the bankruptcy estate files its own tax return, Form 1041, U.S. Income Tax Return for Estates and Trusts.9Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts Administrative expenses incurred by the estate (trustee fees, related attorney fees) are generally deducted on Form 1041, not the individual’s Form 1040. IRS Publication 908, Bankruptcy Tax Guide, provides details on these responsibilities.10Internal Revenue Service. About Publication 908, Bankruptcy Tax Guide
For bankruptcy costs potentially related to investment activities, the rules have changed. The Tax Cuts and Jobs Act suspended miscellaneous itemized deductions subject to the 2% of adjusted gross income floor for tax years 2018 through 2025. Consequently, during this period, legal and administrative costs related purely to personal investments within a bankruptcy context are generally not deductible on an individual’s federal return.