Income Taxes for Bankrupt Individuals

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 What is Bankruptcy?

Bankruptcy is a process designed to help individuals and/or businesses eliminate debt and/or repay debts under the protection of the bankruptcy court. There are many different chapters of bankruptcy that a debtor may file for, such as Chapter 7, Chapter 11, and Chapter 13. The type of bankruptcy chosen will generally depend on the requirements. For example, Chapter 13 is only available to individuals.

There are two general categories of bankruptcy known as liquidation or reorganization. A liquidation bankruptcy, or Chapter 7 bankruptcy, occurs when an individual or a business requests the court discharge all debts which are eligible for discharge. In exchange, the individual’s property or the businesses’ assets will be sold, or liquidated, and the proceeds will be used to pay off creditors. This bankruptcy is typically used by individuals.

Chapter 7 is the most common type of bankruptcy for which individuals file. It is ideal for individuals with low income and high amounts of debt that need quick relief. Individuals who successfully petition for a Chapter 7 bankruptcy will receive a discharge. This means they will be permanently released from their debts.

A reorganization bankruptcy, or Chapter 11 bankruptcy, includes filing a plan outlining how the individual will repay their debt. Some debts are required to be paid in full. Other debts require only a percentage to be paid off. Some are not required to be paid back.

Chapter 11 bankruptcy is available to corporations, partnerships, and individuals. There are no limits on the amount of debt that can be included. Chapter 11 is usually the bankruptcy choice for large businesses that are seeking to restructure their debt in order to become profitable again. This type of bankruptcy is the most flexible but is generally more expensive to the debtor. 

What are Income Taxes for Bankrupt Individuals?

An individual who files for a Chapter 7 or Chapter 11 bankruptcy creates an entirely separate taxable entity called a bankruptcy estate. A bankruptcy estate includes assets owned by an individual prior to filing for bankruptcy. It is typically managed by a court appointed trustee or fiduciary. 

During the time period between the initiation of the bankruptcy and the conclusion of the bankruptcy proceedings, the bankruptcy estate may incur expenses and generate income. Income taxes are imposed on the bankruptcy estate if it includes taxable income after deducting the expenses and standard deductions.

What is a Bankruptcy Court?

Bankruptcy courts differ from those with which most individuals are familiar. Bankruptcy courts are specialized courts within the United States District Court system. These courts have authority over all aspects of bankruptcy proceedings. They are used to resolve issues between creditors and individuals who cannot pay their debts.

A bankruptcy court has limited jurisdiction compared to other courts. It can only hear bankruptcy issues. If some other issue arises out of the bankruptcy, such as a modification of child support payments, the bankruptcy court cannot hear it. A decision made by a bankruptcy judge is binding.

Once a bankruptcy is finalized, an individual is no longer liable for the debts incurred or they are required to adhere to a payment plan in order to keep their property. The bankruptcy court enters a discharge order releasing the debtor from their debts, with some exceptions such as child support. 

The debtor then gets to start over with a clean financial slate. It is important to note, however, that the bankruptcy can remain on their credit report for up to 10 years. 

What Happens if the Bankruptcy Petition Does Not Get Approved by the Courts?

If a bankruptcy petition does not get approved by the court, no bankruptcy estate is created. However, the petitioner is permitted to appeal an unfavorable ruling by the bankruptcy judge. This type of appeal is made in district court.

It is important to note that the appeal may be heard by a panel of three judges. If a petitioner is not satisfied with the initial appeal, they can file an appeal with the appropriate court of appeals.

The bankruptcy appeals process is different from the appeals process in other courts. A bankruptcy court decision can be appealed. An appeal in bankruptcy court is handled differently than in other courts. 

Bankruptcy courts were created by Congress. They did not originate in the Constitution. Therefore, a bankruptcy appeal begins in a federal trial court instead of an appeals court. Some circuits handle an appeal using a Bankruptcy Appellate Panel (BAP), which is a panel of three judges that review the decision of the bankruptcy court. Circuits that use a BAP include:

  • First; 
  • Sixth; 
  • Eighth; 
  • Ninth; and 
  • Tenth.

How does an Individual Appeal a Bankruptcy Court Decision?

Generally, the appeals process begins with a BAP or the United States District Court, depending on the jurisdiction. In order for an appeal to succeed, there must have been wrongdoing and/or failure by the bankruptcy judge. A simple dislike of the outcome will not make a successful appeal.

For jurisdictions that use a BAP, the parties must agree the BAP can hear the appeal. The procedures for BAPs vary by jurisdiction. If the parties do not agree on a BAP, the appeal will be heard in the United States District Court where the bankruptcy case was filed.

What Does “Separate Taxable Entity” Mean?

When an individual files for bankruptcy, a bankruptcy estate is created that has unique tax liabilities and tax return filing responsibilities. Typically, the trustee or fiduciary will be responsible for the tax filing requirements of the bankruptcy estate.

How is Income Tax for a Bankruptcy Estate Calculated?

Income tax for a bankruptcy estate is calculated in the same manner as the calculation for  an individual taxpayer. The biggest difference between the two is that the bankruptcy estate can only use the standard deduction for a married individual filing a separate return.

Does the Home Sale Exclusion Apply to a Bankruptcy Estate?

Yes, the home sale exclusion applies to a bankruptcy estate that is selling a qualified principal residence just as it applies to an individual taxpayer. If the bankruptcy estate is required to sell an appreciated home in order to settle any liabilities, it is entitled to exclude part of the resulting gain from taxation if the home qualifies as a principal residence. 

It is important to note that transfers of property between the bankrupt individual and the bankruptcy estate are not subject to taxation.

What Happens if the Bankruptcy Estate Has a Net Loss?

If the expenses of the bankruptcy estate exceed the income that it generates, that loss is known as excessive administrative cost. An excessive administrative cost may be used to offset the income of the bankruptcy estate in prior tax years, if necessary, and the income of the bankrupt individual in the year prior to the bankruptcy proceedings.

Do I Need an Attorney to Help with Tax Issues?

Tax laws are extremely complex and always changing. Although there may be various tax preparation programs available, they cannot provide you the same level of service that an experienced and knowledgeable bankruptcy attorney can. It is essential to have an attorney help you with any tax issues.

This is especially true regarding your bankruptcy claim. If you are filing for bankruptcy, are seeking to discharge debts, and/or are unsure about your tax responsibilities, a tax lawyer can help. A lawyer can also represent you in bankruptcy court or before the IRS, if necessary. Even if you have already begun bankruptcy proceedings, an attorney can begin helping at any time.

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