Forgive and Forget? Decoding Bankruptcy Debt Forgiveness Rul
January 1, 2010
By Maxine Magri, CPA
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, signed by President Bush on April 20, 2005, had two main objectives: reduce the number of debt categories that could be discharged and force more debtors to file Chapter 13 bankruptcy rather than Chapter 7.
Chapter 7 is a liquidation in which a business goes out of business, while Chapter 13 allows individuals in the United States to undergo a financial reorganization supervised by a federal bankruptcy court, requiring one monthly payment to a trustee who distributes the same according to bankruptcy rules.
Terms to become familiar with in bankruptcy include nondischargeable debt (debt that cannot be eliminated through bankruptcy), dischargeable debt (debt the debtor does not have to pay) and protected assets. Protected assets can be excluded or exempted.
Chapter 7 bankruptcy offers immediate, complete relief of many oppressive debts, and could eliminate unsecured debt, credit cards, payday loans and medical bills. Chapter 7 bankruptcy cannot be used by debtors who earn more than the median income in their states and who can repay at least $100 a month for five years. Because there is little or no nonexempt property in most Chapter 7 cases, there may be an actual liquidation of the debtor’s assets. These cases are called “no asset cases.” The debtor receives a discharge just a few months after the petition is filed.
Commercial enterprises that desire to continue operations will often file for bankruptcy under Chapter 11, in which the debtor can terminate burdensome contracts and leases, recover assets and change operations in order to return to profitability. The debtor generally goes through a period of consolidation and emerges with a reduced debt loan and a reorganized business.
Tax debt
Is bankruptcy an option for the client who owes back taxes? For Chapter 13 bankruptcy, the debtor must have filed all taxes for the four-year period prior to filing the bankruptcy petition.
There are five rules that must all be satisfied to discharge income taxes in either Chapter 7 or Chapter 13 bankruptcy. The rules apply to both federal and state taxes, and the most common infraction that keeps an individual from qualifying is the failure to file the tax return. The tax rules can be found in 11 USC Section 507 and section 523. The five items are as follows:
- The most recent due date for filing the return is more than three years old.
- The tax return was filed more than two years ago.
- The assessment is more than 240 days old.
- The tax return must not have been fraudulent.
- The taxpayer must not have been guilty of a willful attempt to defeat or evade the tax.
The law specifically states that back taxes related to nonfiled or late filed returns cannot be discharged. Nondischargeable taxes include federal, state and local taxes that became due within three years of filing for bankruptcy, and also include trust fund taxes. Additionally, trust fund taxes include employees’ withholding and employers’ share of Social Security and Medicare taxes.
The age of the debt does not matter. Nondischargeable debt includes loans the debtor borrows to pay the nondischargeable taxes, and penalties and interest associated with the taxes are nondischargeable. Although, in some cases, Chapter 13 penalties are dischargeable to the same extent as any general unsecured debt.1
Even though the taxes, interest and penalties are discharged, the tax liability has often been secured with a filed tax lien — and the basic rule is that a properly filed tax lien survives bankruptcy.1
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