Filing for bankruptcy is a difficult financial decision, but it may be the only option for those struggling with overwhelming debts. And while many people know how bankruptcy may impact their credit, not all are aware of how it affects your income tax.
Do you need to report your bankruptcy to the IRS? Will you have to forfeit future tax refunds?
Bankruptcy may help with tax obligations
Even if you declare bankruptcy, you must still file a tax return. Furthermore, it’s imperative to file on time to avoid penalties. But, your filing process changes somewhat. You will still need to file your 1040. In addition, a separate taxable entity, called a “bankruptcy estate,” is created, and a trustee is appointed. The trustee may need to file a U.S. Bankruptcy Estate tax return (Form 1041).
Under a Chapter 7 bankruptcy, you will need to liquidate all non-exempt assets to satisfy creditors, including the IRS. However, older income tax debts may be discharged. Furthermore, any refunds for the period before you filed for bankruptcy are part of the bankruptcy estate and will go towards paying your creditors. Refunds received after you file do not need to be a part of the estate.
For example, you file for bankruptcy in October 2023. In February 2024, you file your taxes. Any refund based on the income from January – October is part of the bankruptcy estate. Any future refunds are yours.
While a chapter 7 bankruptcy allows you a fresh financial beginning, the legal aspects are complex and multifaceted. Consequently, it’s crucial that you work with someone who can guide you through this process.