Income Taxes and Bankruptcy

Filing for Chapter 7 bankruptcy involves specific requirements and carries implications regarding income taxes and bankruptcy for individuals. These implications may include focusing on filing requirements, the creation of a separate bankruptcy estate, the dischargeability of certain older tax debts, and tax refunds as potential assets. 

Pre-Filing Tax Requirements

Before filing for Chapter 7 bankruptcy, the debtor must ensure they are current on their tax filings. 

• Filing all required returns: You must have filed all required tax returns for tax periods ending within four years of your bankruptcy filing. Failure to file returns can prevent the associated tax debts from being discharged.
• Providing tax documents to the trustee: Debtors are required to provide the assigned case trustee with a copy of their most recent tax return or transcripts, as well as any returns filed during the case for prior unfiled years. 

The Bankruptcy Estate and Tax Filings

Upon filing for Chapter 7, a separate bankruptcy estate is created for individuals, which is a new taxable entity distinct from you as an individual taxpayer. 

• Debtor’s responsibility (Form 1040): You, the debtor, must continue to file your individual tax return (Form 1040 or 1040-SR) as you normally would for any income, deductions, and credits that do not belong to the bankruptcy estate.
• Trustee’s responsibility (Form 1041): The Chapter 7 trustee is responsible for filing U.S. Income Tax Return for Estates and Trusts (Form 1041) for the bankruptcy estate if it has sufficient income. The trustee must also pay any taxes due by the estate.
• Tax year election: Individual debtors may elect to divide their tax year into two “short” tax years: one pre-petition and one post-petition. This can sometimes offer tax savings, and the decision should be discussed with a tax professional or bankruptcy attorney. 

Dischargeability of Tax Debts

Most tax debts are considered priority debts and are generally not dischargeable in Chapter 7 bankruptcy. However, certain income tax debts may be discharged if specific criteria are met: 

• Age of the tax debt: The due date for the tax return (including extensions) must have been at least three years before you file for bankruptcy.
• Filing requirement: The tax return must have been filed at least two years before you filed for bankruptcy.
• Assessment period: The tax must have been assessed by the taxing authority at least 240 days before the bankruptcy filing.
• No fraud or evasion: The return must not have been fraudulent, and you must not have been guilty of tax evasion. 

If the income tax debt is discharged, any related interest and penalties may also be discharged. 

Tax Refunds as Assets 

Any tax refund you are due at the time of filing your bankruptcy petition generally becomes an asset of the bankruptcy estate. The Chapter 7 trustee has the authority to collect this refund to pay your creditors. Certain exemptions may allow you to protect a portion or all of your refund, which is something to discuss with your bankruptcy attorney. 

What is Not Taxable

Importantly, the amount of any debt canceled by reason of the bankruptcy discharge is not considered taxable income to you. 

How RJS LAW Can Help

If you are dealing with mounting debt and are considering filing for bankruptcy, it is important to develop a viable strategy. RJS LAW and its qualified tax and bankruptcy attorneys are available to assist in understanding and completing the process as well as with determining a succinct filing timetable. Please call RJS LAW for a free confidential consultation and assessment at (619) 595-1655.  We look forward to hearing from you.

Written by Andy Epstein, Esq., CPA, LL.M. (Taxation)

Certified by the State Bar of California as both a bankruptcy and taxation specialist.