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Bankruptcy and Taxes

It seems that anything you do nowadays is going to have tax consequences, so it shouldn’t surprise anyone that bankruptcy will have a few tax consequences of its own. Make sure you are informed about the laws regarding bankruptcy and taxes starting with noting down the difference between the consequences attached to each type of bankruptcy filing.

Don’t wait until the last minute – get acquainted with the tax consequences of filing for bankruptcy right away. It will help in the decision making process as you determine if filing for bankruptcy is the best move for you and your family.

First we’ll focus on the “positive consequences” or benefits: your discharged debt won’t really have an impact on your taxes because it isn’t counted as taxable income. Following immediately after the good news is always the bad news: you may not be able to take certain deductions you might otherwise have been eligible if you didn’t file for bankruptcy.

When filing for Chapter 7 bankruptcy, two separate estates are created (the individual estate and the bankruptcy estate). If you are married and you and your spouse file a joint bankruptcy petition, the bankruptcy trustee assigned to your case will handle both “estates.” When it comes to taxes, each of the estates is treated separately.

If you have recently declared Chapter 7 bankruptcy, you are still responsible for sending in an individual tax return to the IRS. The only thing that changes due to filing for bankruptcy is that you won’t include any income, credits, or deductions that now belong to the separate bankruptcy estate. Some choose to end their tax year the day before they file for bankruptcy. Any tax that was due at that time is then considered a claim against the bankruptcy estate. It IS possible that you could be required to pay those taxes after you file. A separate income tax return must be filed for any income that you earn during the rest of the year.

The trustee managing the bankruptcy estate is responsible for preparing and filing the income tax return associated with the bankruptcy estate. Upon case closure, remaining assets in the bankruptcy estate are returned to the filer with no tax consequences.

As soon as a bankruptcy petition is filed, an automatic stay goes into effect. Any and all collection efforts by creditors must stop immediately. All legal proceedings against the filer are suspended (including any legal actions being taken by the IRS). Please take note that the automatic stay does NOT stop the IRS from: conducting an audit, demanding that you file your tax return/s, delivering a notice of tax deficiency, or making tax assessments/providing you with notice demanding payment of assessments.

Generally speaking, when filing for Chapter 7 bankruptcy, the IRS usually can’t take assets (money, property, etc.) to pay income taxes if they became due in the three years preceding your bankruptcy filing. They can, however, file a proof of claim for those taxes. Once the bankruptcy estate has been used to pay creditors, anything left can be used to pay the claim. In many cases, tax claims that are older than 3 years (from the date you file for Chapter 7 bankruptcy) can be removed.

The decision to file can be a major turning point and it’s important to take into consideration all the details of the situation. That includes the tax consequences. If you are still unsure of the potential “side effects” of filing for Chapter 7 bankruptcy, contact the southern California bankruptcy attorneys at Westgate Law today.

About the Author

Justin Harelik

Justin has a singular goal: to get people out of financial distress and move them to financial stability and prosperity. He does this by combining 15 years of in-depth experience in bankruptcy, credit management, debt negotiation and student loan modifications, and he does it with both English and Spanish-speaking clients.

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