Income Taxes and Bankruptcy: Three Fundamental Issues
There are three basic concerns about income taxes in Chapter 7 bankruptcy: (1) Do you have unfiled returns? (2) Do you owe unpaid income taxes? and (3) Are you owed any income tax refunds? Let’s examine the importance of each of these questions.
Unfiled Income Tax Returns
The Bankruptcy Code requires that your state and federal income tax returns be filed for each of the four tax years ending immediately prior to the filing of your bankruptcy case, and any tax year ending during your case. Any creditor, your case trustee, or the U.S. Trustee may demand that you produce proof of their filing at any time during your case. If they are not filed, each of these same parties may file a motion to dismiss your case for cause.
Consequently, you will be asked to provide your attorney proof of filing these tax years before your case is prepared. If your situation is dire (active or impending garnishment) your case can be filed with unfiled returns to be prepared and filed after filing your bankruptcy case, but it will be a matter of extreme urgency that they in fact be prepared and filed. They will need to be prepared, filed, and documentation provided your attorney within the first 3-4 weeks after your case is filed, with limited exceptions.
If you were not required to file one of the years in question, your attorney should prepare a statement under penalty of perjury for you to sign declaring that you were not required to file a return. W-2’s and 1099’s from the year in question will still be needed for your file, if they were generated.
Obviously, tax returns can present an unexpected challenge in obtaining the relief from debt you need. The sooner you speak with an attorney about the situation and its resolution, the better.
Unpaid Income Taxes
The most common understanding with the public is that unpaid income taxes are not discharged (eliminated) in bankruptcy. To a great degree, that is a good understanding of the law, but it is not absolute, and to the extent true, actually rests on two different potential reasons.
Claims for income tax owed for your more recent tax years, years for which you failed to file a return (and now must do so) or years that have seen significant recent remedial action taken by the taxing authority are typically non-dischargeable. This has a lot to do with the general understanding that tax debt is non-dischargeable. The devil is in the details. Leave these details to a professional.
The other cause for income tax debt lingering after bankruptcy is its characterization as secured debt, meaning the debt is the subject of a tax lien. Tax liens cannot be avoided (eliminated) in bankruptcy, unlike some liens. They persist, even if your personal obligation to pay the debt is eliminated. So, you might be left in a circumstance in which the taxing authority cannot levy on your wages or bank accounts after your bankruptcy but continues to hold a lien on your vehicle or real estate, such that the property cannot be transferred or perhaps even refinanced without the government’s receipt of payment.
So, generally speaking, tax debt is not escaped in bankruptcy. But, to the extent that a tax debt (particularly a federal tax debt) dates back several years and is not the subject of tax lien, it might, under certain circumstances, actually be discharged in your Chapter 7 bankruptcy. What to expect in this regard is not usually clearly discernable at the initial consultation but should come into focus during preparation of your case.
Tax Refunds
Tax refunds are the primary asset consumer bankruptcy filers find themselves turning over to their trustees to pay at least part of their debt. Generally speaking, if you are owed a refund and have not received it prior to the filing of your bankruptcy case it will (if of significant size) be demanded from you by your case trustee so that your creditors might be paid at least part of what they are owed. The refund is considered owed to you on a pro-rated basis (for the period Jan. 1st to date of case filing) even during the tax year in which you file your case. So, file a bankruptcy case late in the tax year, and most, though not all, of your refund for that year is subject to trustee demand when the return is eventually filed months later in tax season. Sometimes, this is just the cost of avoiding the disaster of wage garnishment or frozen bank accounts.
Even if you have received your refund, it is all but impossible to save it and emerge from Chapter 7 bankruptcy with a safety net. You can thank your state legislature for that. As a Hoosier, you do not have access to the protections of property from creditor claims built into the federal Bankruptcy Code and must rely on those protections found in the Indiana Code. The Indiana Code protections are stingy, to say the least. Your state legislature determined all of this and continues to hold the key to change. What am I saying? Well, in an individual case (no spouse filing with you) every dollar above $450.00 on deposit, invested (other than some tax-deferred savings), in hand or receivable from others on the day your case is filed is a dollar your case trustee might take to pay your creditors. Bankrupts in other jurisdictions often retain ten times that amount. It seems you haven’t sponsored as many downtown lunches for legislators or donated as much campaign money as the banks. The protections for your physical personal property, such as vehicles, furniture, appliances, etc. are more substantial, but still disappointing in certain instances.
Having the use of your tax refund becomes a matter of careful timing and attention to your attorney. You must be careful, even when receiving it and using it prior to filing, to not make such use of it that your good faith in filing bankruptcy might be questioned. It can cost you access to bankruptcy relief. Put bluntly, you don’t take your $5,000.00 refund check and go to Disney World a month before filing Chapter 7 bankruptcy. You can also create a mess in bankruptcy by repaying family members or business associates even remotely close in time to your bankruptcy… which is to say… within a year prior. Often, people plan to do so when receiving tax refunds. Well, don’t do so without first consulting with an attorney to determine if your intended use of the money will have undesirable consequences. A lot of gray area and possible exceptions to rule exist in this. What to do, and not do, becomes a matter for communication with your attorney, early and often.