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Chapter 7 Bankruptcy and Taxes

chapter 7 bankruptcy and taxes

Bankruptcy is an exhausting process that individuals and corporations may have to go through when they are overburdened by financial obligations. While it provides the opportunity for a fresh start, it is critical to be mindful of the tax implications. In this blog article, we will discuss the tax implications of bankruptcy, assisting you in understanding the potential penalties and providing guidance to help you navigate this complex scenario. 

Taxes After Bankruptcy 

The discharge of debts is one of the key benefits of bankruptcy. It allows people or organizations to erase or restructure their financial commitments. It is important to note, however, that not all obligations, including certain tax debts, are immediately forgiven. Much of it will depend on which type of bankruptcy you file for. 

What is Chapter 7 bankruptcy? 

Chapter 7 bankruptcy is commonly known as “liquidation bankruptcy” or “straight bankruptcy.It’s a legal procedure that allows individuals or corporations to start over financially by erasing the majority of their debts. It is the most common type of personal bankruptcy in the United States. A trustee is appointed in Chapter 7 bankruptcy to oversee the proceedings and manage the debtor’s assets. The primary function of the trustee is to identify any non-exempt assets that can be sold or liquidated to repay creditors. 

What happens to tax debt after filing for Chapter 7 bankruptcy? 

Income taxes can be discharged by filing Chapter 7 bankruptcy if you meet certain requirements including: 

  • Your tax debt is income based (either federal or state) 
  • You did not intentionally evade making tax payments and all actions were lawful 
  • Your tax debt is at least 3 years old 
  • You filed a tax return at least 2 years before filing for bankruptcy. Late returns and substitute returns filed by the IRS generally do not count.
  • The taxes in question were assessed at least 240 days before filing for bankruptcy 

You must note that any tax liens recorded before the bankruptcy will remain in effect. You will still need to pay off the tax lien when you sell the property with the lien attached to it. 

In addition, property taxes owed before the bankruptcy is filed will still be owed. Taxes other than federal and state will also still be due, including FICA, Medicare, sales tax, etc. You should also expect to continue paying certain employment taxes and penalties.  

Filing Tax Returns After Bankruptcy 

When filing, you will use Form 1040 for your individual return and your appointed trustee will file Form 1041 on your behalf, which is the U.S. Income Tax Return for Estates and Trusts. You may receive Form 1099-C, Cancellation of Debt from creditors that canceled $600 or more in debt on your behalf. Typically, any canceled debt should be reported on your tax return as taxable income. However, having debt forgiven through bankruptcy typically exempts an individual from paying taxes on the canceled debt. When your debt is discharged through bankruptcy, you’ll need to file IRS Form 982, About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness to inform the IRS of your discharged debt that should be excluded from your taxable income. 

Tax Help for Bankruptcy Filers 

Compliance with tax return filing and reporting duties is critical throughout bankruptcy. Failure to file tax returns on time and appropriately might result in penalties and further issues. Furthermore, if you file for bankruptcy, you may have extra reporting duties, such as notifying the IRS of your bankruptcy filing. Given the intricacy and potential tax implications of bankruptcy, it is strongly advised to obtain expert guidance. Consulting with both tax professionals and bankruptcy attorneys will give you the knowledge you need to successfully navigate the process. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.  

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