How Does Filing Bankruptcy Affect Your Taxes?

Bankruptcy is a legal process designed to help individuals and businesses facing overwhelming debt obtain a fresh financial start. While primarily a debt relief mechanism, filing for bankruptcy carries significant implications for an individual’s tax obligations and reporting responsibilities. Understanding how bankruptcy interacts with tax law is important, as it can affect existing tax debts, the tax treatment of forgiven debts, and ongoing tax filing requirements.

Handling Existing Tax Debts

Existing tax debts are treated differently in bankruptcy depending on their type, age, and whether all filing requirements were met. Only certain income tax debts may be dischargeable, while other tax obligations, such as payroll taxes or those arising from fraudulent returns, are not. The ability to discharge income tax debt in Chapter 7 and Chapter 13 bankruptcy hinges on specific criteria, known as the “3-2-240 rules.”

For income tax debt to be potentially dischargeable, the tax return for that debt must have been due at least three years before the bankruptcy filing date, including any extensions. It must have been filed at least two years prior to the bankruptcy petition date. The debt must have been assessed by the taxing authority at least 240 days before the bankruptcy filing. If any of these conditions are not met, the income tax debt remains non-dischargeable.

Tax debts are categorized as either “priority” or “non-priority” claims within bankruptcy proceedings, which dictates their treatment. Priority tax claims, such as recent income taxes, certain property taxes, and withholding taxes, are not dischargeable and must be paid in full, often through a Chapter 13 repayment plan. These claims receive precedence over other unsecured debts in the distribution of assets.

Non-priority tax claims, which are older tax debts that meet the dischargeability criteria, are treated like general unsecured debts. While these may be dischargeable in Chapter 7, in a Chapter 13 case, they might be paid only partially, with any remaining balance discharged upon successful completion of the repayment plan. Tax liens are not eliminated by bankruptcy, even if the underlying debt is discharged; the lien remains attached to the property.

Tax Impact of Debt Forgiveness

When debts are canceled or forgiven outside of bankruptcy, the forgiven amount constitutes taxable income to the debtor, known as Cancellation of Debt (COD) income. This rule aims to tax the economic benefit received when a liability is extinguished without repayment. An exception exists for debts discharged through a Title 11 bankruptcy case.

Under Internal Revenue Code Section 108, individuals do not recognize taxable income from the discharge of debts if the discharge occurs as a result of a bankruptcy filing. This provision prevents debtors from incurring a new tax liability while seeking financial relief through bankruptcy. The exception applies to debts discharged in Chapter 7, Chapter 11, and Chapter 13 cases.

Creditors who forgive debts of $600 or more are required to issue Form 1099-C, Cancellation of Debt, to both the debtor and the IRS. Receiving this form does not automatically mean the discharged debt is taxable income. For debts discharged in bankruptcy, the debtor can exclude the amount from their gross income by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

While the debt itself is not taxed, the bankruptcy exclusion for COD income may require a reduction of the debtor’s tax attributes. These attributes include net operating losses, tax credit carryovers, capital loss carryovers, and the basis of property. The reduction of these attributes can affect future tax liabilities, even though the immediate COD income is not taxed.

Tax Reporting During Bankruptcy

Filing for bankruptcy, particularly under Chapter 7 or Chapter 11, can alter an individual’s tax filing responsibilities by creating a separate taxable entity known as a “bankruptcy estate.” This estate is distinct from the individual debtor for tax purposes. The creation of this estate occurs at the time the bankruptcy petition is filed.

For Chapter 7 and Chapter 11 cases, a bankruptcy trustee is appointed to manage the estate’s assets and is responsible for preparing and filing its tax returns. The bankruptcy estate may be required to file its own income tax return, Form 1041, U.S. Income Tax Return for Estates and Trusts, if its gross income meets or exceeds a certain threshold, which is the basic standard deduction amount for a married individual filing separately. The trustee must also obtain a separate Employer Identification Number (EIN) for the estate.

The Form 1041 for the bankruptcy estate reports income, deductions, and credits related to the assets and activities of the estate. This includes income earned by the estate after the bankruptcy filing. The individual debtor continues to file their own Form 1040, U.S. Individual Income Tax Return, for income not belonging to the estate, such as wages earned after the bankruptcy filing date. In some instances, such as a Chapter 11 debtor-in-possession, the debtor might be responsible for filing both their personal Form 1040 and the estate’s Form 1041.

The tax year of the bankruptcy estate can differ from the debtor’s, and the trustee may elect to close the estate’s tax year early. This allows for a prompt determination of the estate’s tax liability and can be strategically used to manage the tax implications of income and deductions. If the bankruptcy case is dismissed, the estate is not treated as a separate taxable entity, and any income and deductions reported by the estate must be moved back to the debtor’s returns.

Additional Tax Considerations

Beyond the treatment of existing tax debts and the tax implications of debt forgiveness, other tax considerations arise during bankruptcy. Tax refunds are considered property of the bankruptcy estate, particularly for income earned before the bankruptcy filing date. In a Chapter 7 case, a tax refund for a pre-petition period may be claimed by the trustee to pay creditors, unless it is protected by state or federal exemptions. In Chapter 13, tax refunds received during the repayment plan are considered part of the estate and may be used to pay creditors.

Bankruptcy can also affect a debtor’s tax attributes, which are items that can reduce future tax liabilities. Net Operating Losses (NOLs), tax credit carryovers, and capital loss carryovers are examples of tax attributes. Upon the filing of a Chapter 7 or Chapter 11 bankruptcy petition, these pre-petition tax attributes become property of the bankruptcy estate. The estate can then use these attributes to offset its own income or gains.

While the estate uses these attributes, the individual debtor loses access to them. If any unused tax attributes remain when the bankruptcy case is closed, they can revert back to the debtor. This transfer and potential reduction of tax attributes can impact a debtor’s ability to reduce future tax burdens.

In Chapter 13 bankruptcy, while the debtor maintains control of their assets and does not have a separate bankruptcy estate created, tax claims still have specific treatment. Priority tax claims, which are non-dischargeable, must be paid in full through the Chapter 13 repayment plan, which spans three to five years. This structured repayment allows debtors to address their tax obligations over time, without additional collection actions from taxing authorities during the plan.