Debtors & Creditors Face Tax Issues With COVID-19 Related Bankruptcies

Companies/individuals have much to consider when contemplating bankruptcy

Due to the Covid-19 shutdown orders many businesses that have closed or had to substantially reduce operations are contemplating the alternatives available to deal with the crisis. The CARES Act attempted to provide individuals and businesses with some relief, and state and local governments are encouraging or even mandating flexibility in extending payment deadlines to help businesses and individuals through the crisis. However, many individuals and businesses are faced with the possibility that these relief efforts may not be enough to enable them to meet their ongoing obligations. The bankruptcy laws are designed to help businesses and individuals get a fresh start.

When bankruptcy & tax laws intersect, complexity reigns

The bankruptcy laws are very complex, and things get even more complicated when you look at how the bankruptcy laws interact with the tax laws. One basic choice under the bankruptcy laws is whether to file under chapter 7, 11, 12, or 13 of the Bankruptcy Code. The chapter depends on whether you are trying to liquidate or reorganize your debts so that you can continue, and whether you are an individual or a business, and the type of business that you have. Bankruptcy can be a voluntary choice of the debtor or an involuntary bankruptcy imposed by the creditors of the debtor. In the case of businesses, there may be a court appointed receiver.

  • Tax returns must continue to be filed during bankruptcy, either by the bankruptcy trustee, debtor, debtor-in-possession, or more than one of these
  • Filing a short-tax-year return up to the date the bankruptcy petition is filed can qualify taxes for that short-tax-year as a priority claim in bankruptcy
  • For individuals, the bankruptcy estate will generally be treated as a separate taxable entity, which must obtain its own Employer Identification Number (EIN)
  • Bankruptcy estates for individuals pay the tax rates for married couples filing separately
  • Allocations of income and tax withheld may be required between the bankruptcy estate and the debtor, and how those allocations were determined is required to be disclosed in the tax returns
  • Qualified retirement accounts are generally exempt from bankruptcy until paid out; however, there is a limit on the protected amount of IRAs and Roth IRAs, which is currently $1,362,800
  • An individual debtor may want to file a revised Form W-4
  • A debtor’s self-employment earnings continue to be subject to self-employment tax
  • Many federal tax obligations will have a priority claim in bankruptcy and are not discharged
  • Federal tax liens may not be discharged in bankruptcy
  • Debt cancellations are not taxable if the cancellation is part of a bankruptcy case or if the debtor can meet an insolvency test, but they do require an adjustment of basis and/or other tax attributes
  • Unsecured creditors can file a proof of claim in the bankruptcy case, but their claim will come after secured and other priority claims. Creditors with a secured interest in assets of the debtor get high priority in bankruptcy
  • Creditors may be able to claim a bad debt tax write-off if their claim is not fully paid in bankruptcy by the debtor

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Need help sorting through these tax issues?

Tax expert Mark Luscombe, JD, LL.M, CPA, Principal Federal Tax Analyst at Wolters Kluwer Tax & Accounting, can help sort through the various tax issues associated with business and personal bankruptcy filings.

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