5 Tax Traps When Filing For Bankruptcy
by Tyler Claus, JD, LLM
Staff Accountant, Trust & Estate
One significant consequence of the COVID-19 pandemic has been the disruption to the economy. We are in an unemployment crisis now due to COVID-19 business closings, and many people have been accruing debt in order to maintain their basic lives – unpaid utilities, buying food on credit, etc. For many Americans, declaring bankruptcy to wipe out debts may become necessary to get back on their feet, and the last thing most individuals involved in a bankruptcy consider are the tax aspects of a bankruptcy. There are unfortunately a number of tax traps lurking that may impact an individual’s financial well-being post-bankruptcy, and we’ve put together an overview of 5 of them.
Tax filing issues during bankruptcy
For individuals, filing for bankruptcy under chapter 7 or 11 of the Bankruptcy Code results in the creation of a ‘bankruptcy estate.’ This estate generally includes all of the debtor's legal and equitable interests in property as of the commencement date. The bankruptcy estate will generally be treated as a separate taxable entity, which must obtain its own Employer Identification Number (EIN) and file an income tax return.
Election of a Short Tax Year
One of the most important tax considerations relates to the individual debtor's ability to make an election to treat his tax year in which the bankruptcy case commences as two tax years and file a return for each of the two resulting years. Depending on the individual debtor's circumstances, this election can result in substantial federal income tax savings to the debtor.
Forgiveness of Debt May Trigger Taxable cancellation of Debt (COD) Income
Generally, when a debt owed to another person or entity is canceled, the amount canceled or forgiven is considered Cancellation of Debt (“COD”) income that is taxed to the person owing the debt. This is frequently a surprise to the taxpayer, who may have never considered the debt written off as “income.”
Tax attributes may become limited after a bankruptcy
Even if the COD income is excluded from gross income when cancelled as part of a bankruptcy case by IRC § 108(a), certain ‘tax attributes’ transferred from the individual debtor to the bankruptcy estate, such as net operating loss (“NOL”) carry forwards, may be affected as a result of the discharge. Another exception to the general rule of taxability for debt cancellation transactions as part of bankruptcy is the “reduction in basis in depreciable property exception” under IRC § 108(b)(5).
Not All Tax Debts Are Discharged in Bankruptcy
When individuals file for bankruptcy, they can discharge some tax debt, but not all. Income tax debts might be eligible for discharge under Chapter 7 or Chapter 13 of the Bankruptcy Code, depending on the age of the debts and other criteria. Yet most other types of tax debt are not dischargeable.
The takeaway…
Bankruptcy laws are very complex and become even more complicated when they interact with tax laws. As demonstrated above, there are a number of actions in bankruptcy that can create unintended tax consequences if they are mishandled.