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Bankruptcy: Everything You Need to Know

What happens if I declare bankruptcy?

Debt comes in many forms and can be completely overwhelming. Are you being harassed by creditors, unable to make minimum payments, or at risk of losing your house? Bankruptcy might be your best option to ward off creditors, renegotiate your monthly payments, or keep your home. This should be a last resort, however, because there are long-term consequences to consider. If you can prove in bankruptcy court that you can’t afford to pay your debts, a successful filing will allow you to create a repayment plan or forgive your debts completely. While you might not have to stand in front of a judge, you will have to take a debtor education course which will teach you about budgeting and managing your money. Once the process is complete, your bankruptcy will show up on your credit report for 7 to 10 years.

This major hit to your credit score will show up any time you need to open a line of credit, open a utility account, or apply for a job. This may be the best option you have, but it should not be taken lightly. Check out our blog on personal finance: The Cure for the Common Finances

Chapter 13 bankruptcy

There are several types of bankruptcy an individual can file for and there are many requirements for each, so it is important to consult a lawyer to counsel you on what is right for your situation. A Chapter 13 bankruptcy is called a wage earner’s plan because it will allow you to develop a repayment plan to pay back all or part of your debt on a monthly basis. The terms of repayment are typically set up by laying out a Chapter 13 repayment plan. The repayment prioritizes debt such as filing fees, attorney fees, alimony, tax debt, mortgage payment and unpaid wages to be paid in full. Other debts may be forgiven or paid in part depending on your financial situation and ability to pay.

Chapter 7 bankruptcy

If you determine that a Chapter 13 repayment plan is out of the question, Chapter 7 bankruptcy might be the best option for you. The benefits of filing Chapter 7 bankruptcy include an automatic stay that immediately stops creditors from trying to collect your debt with the goal of liquidation. This temporary block from collections actions will protect your paychecks, property, and bank accounts for a period. During this time, the court will determine if you have anything worth selling, or any transactions that can be reversed in order to pay as much debt as possible. Once the process is complete, you will have your debts discharged completely except certain debts including federal taxes, child support, student loans, and anything else the courts determine to be exempt.

Chapter 11 bankruptcy

Chapter 11 bankruptcy is typically filed by corporations to gain time to restructure their debts. This is the most complex type of bankruptcy proceedings, so this should be the last resort for corporations looking to reorganize. Reorganization plans may include downsizing, reducing expenses, renegotiating expenses, and liquidating assets. The benefits of Chapter 11 to a large organization include the ability to continue operating and restructure debts to stay afloat. While this option is mostly used by business entities, such as corporations, individuals have filed Chapter 11 when they don’t qualify for Chapter 7 or 13. Businesses in the midst of this type of court proceeding will be able to carry on business as usual, but there will be limits put in place by the courts. These limits involve decisions regarding assets, legal agreements, and certain other business decisions.

Tax implications of bankruptcy

The bankruptcy court will need to see your past three years of tax returns, so it is important to catch up if you have fallen behind. Once you have successfully filed for bankruptcy, you will have new filing requirements with the IRS. There will be aspects of the bankruptcy that can affect your individual return, but in a Chapter 7 bankruptcy you will also be required to file a bankruptcy estate tax return. Form 1041 estate tax returns are required when filing Chapter 7 because your assets and affairs are being handled by an estate to pay off creditors. Estates range in complexity, but commonly occur when an individual passes or become incapacitated. The IRS expects that any income earned by the estate is reported by the estate and that taxes are paid accordingly.

Cancellation of Debt

The IRS considers a forgiven debt to be income in situations such as forgiving credit card debt. This is a general rule, but usually does not apply to debts discharged in a bankruptcy or as a gift. There are situations where this forgiven debt will need to be included in your income. If a lender files a 1099-C Cancellation of Debt with the IRS before you file for bankruptcy, you will have to report this cancelled debt as income on your tax return. An exception to this situation occurs when you are insolvent, meaning that the total amount of your debts exceeds the total value of your assets.

Is there tax relief through bankruptcy?

As I mentioned earlier, federal tax debt is not easily resolved through bankruptcy filing. The IRS requires that certain rules be met before individual income taxes can discharged through Chapter 7 bankruptcy. The requirement that the last two years of tax returns are filed applies to most bankruptcy proceedings. New tax debt does not qualify for bankruptcy discharge, but past due taxes greater than 3 years old may qualify. If you have tax debts that can’t be erased through bankruptcy, the IRS offers alternatives. Before making any important tax decision, contact an advisor at Molen & Associates to solve your tax headaches. If the tax debt is from unfiled returns or taxes assessed in error, filing original or amended returns can cut down on your IRS debt significantly!

Another common option to paying off your taxes is setting up or renegotiating a payment plan. Your debts will continue to gain interest, but the IRS will consider you to be in compliance. An offer in compromise is an IRS program that involves a negotiation to pay what taxes you can, and have the rest forgiven. While there is no ‘one size fits all’ approach, our advisors can help you get the relief you need.

Austin Long
Tax Advisor, EA

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