When considering filing for bankruptcy, it’s important for individuals and businesses to be aware of certain requirements and caveats for tax purposes.
According to IRS Publication 908, Bankruptcy Tax Guide, the Bankruptcy Code requires a debtor to file an individual tax return, or request an extension. In addition the bankruptcy trustee is required to file a fiduciary tax return, form 1041, for the bankruptcy estate. The confusion for taxpayers in bankruptcy springs from the requirement for the filing of two types of tax forms. One is for the individual and the other is for the bankruptcy estate. This is true for both Chapter 7 and 11 filings.
Forgiveness of Debt
For the most part there is no negative tax consequence in filing for Chapter 7 bankruptcy. In fact, if there is an impending foreclosure on your house or if you are going to surrender it to the lender, there is a positive tax consequence.
Any foreclosure, surrender, deed in lieu of foreclosure, or short sale, involves the recognition of a certain kind of income if the deficiency is waived by the lender. That income is called discharge-of-indebtedness income or sometimes known as cancellation of debt income (debt forgiveness). It occurs when the house is worth less than the balance due on the loans (the deficiency).
If the lender does not attempt to collect the deficiency, that is to say the lender waives the deficiency, that waiver is treated as income to the debtor. However, Section 108(a)(1)(A) of the Internal Revenue Code excludes cancellation of debt income. The IRS has form 982, entitled “Reduction of Tax Attributes Due to Discharge of Debt,” that can be filed with a return to indicate the exception.
Even though the law is clear that discharged debts are not to be treated as taxable income, some creditors erroneously believe that they are required to send a bankruptcy debtor a form 1099-C when a debt is discharged in bankruptcy. Obviously this causes confusion to tax preparers who are often accustomed to including all income reflected in 1099 forms as income to the taxpayer.
Another common question is how are the taxes I owe to the IRS treated at the time the bankruptcy is filed. If you follow certain provisions it is possible to avoid having to pay outstanding taxes owed. The IRS requires that all tax returns that are represented in the bankruptcy estate must have been filed with the IRS, the liability cannot stem from a Substitute Filed Return (SFR) prepared by the IRS.In addition there must not have been fraud or willful evasion involved with the filing of any of the tax returns eligible for discharge.
Finally it’s important to note that the trust fund portion of payroll tax liabilities (the withholdings from an employee’s pay) can never be discharged in bankruptcy. Nor can civil penalties associated with failure to file and pay payroll taxes be discharged.
Remember while past taxes might have been discharged in the bankruptcy, beware of new taxes — or any other new debt. Again, though, the most important thing is to file a return, even if you know you will owe taxes, and then try to work out a payment plan through the IRS if you are unable to pay the full amount due.
One of the first and most important things to do when considering filing for bankruptcy is to consult with an attorney who specializes in the area. Bankruptcy involves both legal and tax implications, and having a team of advisors who understand the various sometimes complicated aspects are extremely important as decisions are made.