How Bankruptcy Handles . . . Income Taxes You Expect to Owe for the Current Tax Year
You can put into your bankruptcy case the taxes you expect to owe for a portion of the tax year, by filing a partial-year tax return.
Income Taxes Owed During the Current Ongoing Tax Year
If you’ve had your income tax returns prepared for last year and you owe a substantial amount of taxes for that year, you could very well end up also owing for the current tax year.
For example, you may owe for last year because you did not have enough income taxes withheld by your employer. Or you did not pay enough quarterly estimated taxes if you are self-employed and/or own your own business. Then if you continued that underwithholding or underpayment into the current year, you’re likely going to owe again this year.
The good news is that either Chapter 7 or Chapter 13 can often help even with recent income taxes, but only if that tax is owed as of the time your bankruptcy case is filed. The tax is not owed if the tax period for which the tax is owed has not been completed at the point when the bankruptcy case is filed.
Accelerating a Tax Debt through a Partial-Year Tax Return
This problem can often be solved by submitting to the IRS (and, where applicable, to the state tax agency) a partial-year tax return immediately before you file your bankruptcy case. Your election to split your normal tax year into two results in having any tax that is owed from the partial-year tax return count as a debt as of the time the bankruptcy case is filed.
How this Can Help Under Chapter 7
Candidly, a partial tax return will not likely make much difference in most Chapter 7 “straight bankruptcy” cases. But it can make an important difference in certain situations.
Generally, Chapter 7 will “discharge” (legally write off) some, mostly older, income taxes. It will have no effect on the rest, including any from the last tax year, or the present year, for that matter. Any taxes that don’t get discharged, you have to deal with directly with the IRS/state, through monthly payments, a settlement, or some other arrangement. So usually any taxes owed during the current year is not going to make a meaningful difference.
The exception is if you have an “asset” Chapter 7 case—the somewhat unusual situation in which your assets are not all “exempt,” not all protected from the reach of your bankruptcy trustee and the creditors that he or she represents. Here the trustee is claiming some of your assets to liquidate and distribute to your creditors. If this happens, your recent income tax debt, as a “priority” debt, gets paid out of what the trust is distributing before the regular “general unsecured” debts are paid anything. So, naturally you would want all your income taxes to be accounted for and, to the extent possible, paid out of the assets being distributed. That could make preparing a partial tax return worthwhile.
How this Can Help Under Chapter 13
It’s much more likely that a partial-year tax return would be helpful under a Chapter 13 “adjustment of debts” case.
Chapter 13s are often used to deal with income tax debts, especially if there is more than one tax year owed. Chapter 13 cases involve ongoing monthly Plan payments lasting an extended time—3 to 5 years—put together through a careful budgeting process, taking into account all the debts on the table. So having a new debt of an unknown amount show up on the scene months after the case is filed—that current year’s tax determined once the full-year tax returns are prepared—is at the very least awkward, and expensive to deal with. In particularly sensitive cases it may even jeopardize the viability of the case.
Instead, filing a partial-year tax return allows everyone to know what that tax liability is from the start so that it can be incorporated into the Chapter 13 Plan. And the budget from that date forward can include the appropriate amounts withheld for income, Medicare, and other employment taxes, or for self-employment taxes. Chapter 13 cases have enough challenges with the changes that life can bring. It’s much better to avoid starting out a case with a significant unknown debt ready to jeopardize the case soon after it gets off the ground.
The Usual Tax Caution
As with any tax decision, this one about filing a partial-year tax return has many other possible consequences unrelated to our discussion here. So of course you need to talk with your tax professional before going ahead with it. But, especially in situations with a large current-year tax liability, it’s an option that most people aren’t aware of and it should be at least considered.