Navigating Taxes When a Client Files for Bankruptcy

The Covid-19 pandemic continues to shake the U.S. economy. This uncertainty is leading experts to believe that personal and business bankruptcies will rise exponentially in the coming months. Bankruptcy is one of the last resources for a client dealing with financial troubles; yet, it’s one that involves a myriad of decisions regarding taxes.

According to the Administrative Office of the U.S. Courts, bankruptcy filings had fallen slightly for the year ending March 31. Then, cases of the coronavirus surged across the country causing severe money glitches for businesses and individuals. Now it seems that 2020 is on track to have the highest number of retail bankruptcies in a decade.

As most people are aware, the two most common categories of bankruptcy are Chapter 7 and Chapter 13. The difference is that Chapter 7 is a complete debt-forgiveness plan, with the exception of taxes, child support, and alimony. Chapter 13, on the other hand, is a combination of debt-forgiveness, along with a repayment plan. This is calculated by establishing a repayment percentage of assets, size of debts, and total income.

For those considering filing bankruptcy, it’s worth noting that current tax returns must be filed first. This information will determine your tax liability, but in most cases, you won’t have to pay any taxes back right away.

However, the IRS does note that during a bankruptcy case you should pay all taxes that are owed from previous years. Failure to file these returns or take care of current taxes during your bankruptcy could cause a tax case to be dismissed.

Many people believe that taxes can’t be discharged or forgiven during bankruptcy. That is simply not the case. There are limits to what can be forgiven, and typically the taxes owed must be more than three years old to qualify.

Keeping that in mind, it’s important to decide when the right time is for you to file bankruptcy if you owe a great deal of taxes. Be sure to do the math to ensure you’re waiting until those back-taxes are three years old before filing. If you choose to file prematurely, be prepared for those taxes not to be discharged. You’ll have to weigh the pros and cons of filing soon or waiting before making such an important decision. Speaking with a financial advisor is definitely the best route to take when contemplating bankruptcy. They can help you navigate the entire process and recommend when you should file based upon your unique circumstances.

Something else to consider when filing bankruptcy is whether you’re willing to risk losing your home. Although this scenario is scary and emotional, sometimes it is the smartest thing you can do. Again, this is something that can be discussed with an expert before making the final decision. A financial advisor might be able to steer you in directions that can help you to avoid filing for bankruptcy at all.

For instance, this year people can borrow from their retirement plans or IRAs under the CARES Act. There is no penalty if you’re younger than 59 and a half, and pay taxes back over three years upon distribution. That is just one way people might be able to survive financially without filing bankruptcy during this pandemic.

If that’s not an option, Chapter 7 is still an alternate method of getting personal debts discharged. Yet, that’s not the case for corporations that will not qualify for a discharge. One way of working around this dilemma is to give the corporation away. If the corporation is gone, then the debts are unpayable. This is just an example of why it’s important to speak with someone knowledgeable in the financial field who can help navigate this situation.

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