forgive & forget? decoding bankruptcy debt forgiveness rules

8/14/2019 Forgive & Forget? Decoding Bankruptcy Debt Forgiveness Rules

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By Maxine Magri, CPA

26 Bankruptcy Disclosures January/February

Decoding bankruptcy debtforgiveness rules

Forgive&Forget?


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The Bankruptcy Abuse Preventionand Consumer Protection Act o2005, signed by President Bushon April 20, 2005, had two main objectives:reduce the number o debt categories thatcould be discharged and orce more debtorsto le Chapter 13 bankruptcy rather thanChapter 7.

Chapter 7 is a liquidation in which abusiness goes outo business, while Chapter13 allows individuals in the United Statesto undergo a nancial reorganization su-pervised by a ederal bankruptcy court,requiring one monthly payment to a trusteewho distributes the same according to

bankruptcy rules.Terms to become amiliar with in

bankruptcy include nondischargeable debt(debt that cannot be eliminated through

bankruptcy), dischargeable debt (debt thedebtor does not have to pay) and protected

assets. Protected assets can be excluded orexempted.

Chapter 7 bankruptcy oers immediate,complete relie o many oppressive debts,and could eliminate unsecured debt, creditcards, payday loans and medical bills. Chap-ter 7 bankruptcy cannot be used by debtorswho earn more than the median incomein their states and who can repay at least$100 a month or ve years. Because thereis little or no nonexempt property in mostChapter 7 cases, there may be an actual

liquidation o the debtors assets. Thesecases are called no asset cases. The debtorreceives a discharge just a ew months aterthe petition is led.

Commercial enterprises that desireto continue operations will oten le or

bankruptcy under Chapter 11, in which thedebtor can terminate burdensome contractsand leases, recover assets and change opera-tions in order to return to protability. Thedebtor generally goes through a period oconsolidation and emerges with a reduceddebt loan and a reorganized business.

Tax debtIs bankruptcy an option or the client

who owes back taxes? For Chapter 13bankruptcy, the debtor must have led alltaxes or the our-year period prior to lingthe bankruptcy petition.

There are ive rules that must all besatisfed to discharge income taxes in eitherChapter 7 or Chapter 13 bankruptcy. Therules apply to both ederal and state taxes,and the most common inraction that w

Bankruptcy Disclosures January/February 27

Chapter 7 bankruptcy

offers immediate,

complete relief of many

oppressive debts, and

could eliminate un-

secured debt, credit

cards, payday loans

and medical bills.


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keeps an individual rom qualiying is theailure to le the tax return. The tax rulescan be ound in 11 USC Section 507 andSection 523. The ive items are as ol-lows:

1. The most recent due date or lingthe return is more than three years

old.2. The tax return was led more thantwo years ago.

3. The assessment is more than 240days old.

4. The tax return must not have beenraudulent.

5. The taxpayer must not have beenguilty o a willul attempt to deeator evade the tax.

The law specically states that back taxesrelated to noniled or late iled returns

cannot be discharged. Nondischarge-able taxes include ederal, state and localtaxes that became due within three yearso ling or bankruptcy, and also includetrust und taxes. Additionally, trust undtaxes include employees withholding andemployers share o Social Security andMedicare taxes.

The age o the debt does not matter.Nondischargeable debt includes loans thedebtor borrows to pay the nondischargeabletaxes, and penalties and interest associated

with the taxes are nondischargeable. Al-though, in some cases, Chapter 13 penaltiesare dischargeable to the same extent as any

general unsecured debt.1

Even though the taxes, interest andpenalties are discharged, the tax liabilityhas oten been secured with a led tax lien

and the basic rule is that a properly ledtax lien survives bankruptcy.1

Individuals who obtain a discharge odebts in bankruptcy ater ve years will

continue to owe taxes, interest and penal-ties that have not been ully paid. O course,they can try to obtain an oer in compro-mise to reduce the liability.

So are there benets or taxpayers whoowe back taxes? The ling o bankruptcyprovides an automatic stay to prevent col-lection activities on the taxes prior to bank-ruptcy ling. Another pro-taxpayer benetis a single interest rate or the computationo interest on tax claims. Bankruptcy canalso stop oreclosure and repossession.

Consumer debtNondischargeable consumer debt in-

cludes court-ordered alimony and childsupport, as well as any debt due to obtain-ing money, property or services by raudor alse pretenses.

Credit card charges or oods and servic-es o more than $500 made within 90 dayso bankruptcy, and cash advances o morethan $750 within 70 days o bankruptcy, arenot dischargeable. Car loans are subject toull repayment.

What about possessions?A new section, 522 ()(4), limits the

nonpossessory, non-purchase money se-cured interest in household goods that can

be avoided under section 521()(1)(B).The denition limits electronic equipmentto one radio, one TV, one VCR and onepersonal computer with related equipment.It excludes works o art not created by thedebtor (or a relative) and jewelry worth

more than $500 (except wedding rings).Section 523(a)(8) is amended to makestudent loans dischargeable, in the absenceo undue hardship, regardless i they arerom nongovernmental and prot-makingorganizations.

In Virginia, bankruptcy law allows an in-dividual to keep clothes worth up to $1,000,household goods worth up to $5,000, carequity up to $2,000, and cash or debtorschoice o valuables up to $5,000. Clothingand household goods can be valued at thritvalue. I the debtor has something o value

over $5,000, the courts will normally sellthe asset to pay o the debts.

Retirement andinsurance investments

Protected unds include traditionaland Roth IRAs (exempted or the rst $1million and indexed or infation). The ex-emption amount is unlimited or employeeretirement plans, SEPs and SIMPLE IRAs.But debtor beware! Employer retirementunds do not keep exempt status i they are

rolled into an IRA. However, i IRAs arerolled into employer retirement unds, theexemption amount is unlimited.2

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Bankruptcy Disclosures January/February 29

The Bankruptcy Abuse Prevention andConsumer Protection Act introduced anew exclusion under section 541(b)(7)that applies to employee contributions toERISA-qualiied retirement plans, tax-deerred annuities, and health insuranceplans. Exclusions rom estate property aregiven to 529 plans and Coverdell education

savings. All contributions to plans madewithin a year o ling bankruptcy are notprotected, and any contributions o one totwo years are protected up to $5,000 per

beneciary or a child, grandchild, step-child, grand-stepchild and, in some cases,a oster child.3

The ederal exemptions or debtorsserve as the deault set o exemptions.However, individual states have the right toelect out o the ederal exemptions and usetheir own list o state exemptions instead.The ederal exemptions apply i the state

is silent. Section 522(b)(3) species thestate or local law governing the debtorsexemption as the law o the place wherethe debtors domicile was located or the730 days beore ling.

Other considerationsDetrimental aspects o ling bankruptcy

include the stigma, and the negative aecton the debtors credit rating. The debtormay be ineligible or some jobs, such asthose in banking and jewelry industries or

jobs requiring bonding.In essence, a person in bankruptcy isescaping the responsibility or money owed.Under the Fair Credit Reporting Act, arecord o the bankruptcy stays on the indi-viduals report or up to 10 years.

The bankruptcy rules are complex,and every debtor can have unique circum-stances, so it is important to seek qualiedcounsel.

1. King, Morgan D., Bankruptcy Reorm Limits,But Does Not Eliminate, Ability to DischargeDelinquent Taxes in Bankruptcy,Journal of Tax

Practice & Procedure, JuneJuly 2005.

2. This strategy has not been tested in courts andcould be questionable.

3. Kitces, Michael E., Retirement Accounts and theBankruptcy Act o 2005: Simplifcation, the OldRules and the New Rules,Journal of RetirementPlanning, JulyAugust 2005.

Maxine Magriis a CPA in Harrisonburg spe-

cializing in consulting and taxation. Contact

her at [email protected]. The Virginia Society of Certied Public Accountants endorses Dominion Benets www.dominionbenets.comDominion Benefts is the administrator o the Virginia Society o Certifed Public Accountants Insurance Service Center

We

know CPAs

Tel 804-422-6722 or 877-998-7272or more ino please visit us at:vscpainsurance.com

EXCLUSIVELYor Virginia Society o CPAMEMBERS

ull-service consultant orhealth, dental and otheremployee benefts.

forgive & forget? decoding bankruptcy debt forgiveness rules

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