Forgive and Forget? Decoding Bankruptcy Debt Forgiveness Rules

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:

1. The most recent due date for filing the return is more than three years old.
2. The tax return was filed more than two years ago.
3. The assessment is more than 240 days old.
4. The tax return must not have been fraudulent.
5. 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

Individuals who obtain a discharge of debts in bankruptcy after five years will continue to owe taxes, interest and penalties that have not been fully paid. Of course, they can try to obtain an offer in compromise to reduce the liability.

So are there benefits for taxpayers who owe back taxes? The filing of bankruptcy provides an automatic stay to prevent collection activities on the taxes prior to bankruptcy filing. Another pro-taxpayer benefit is a single interest rate for the computation of interest on tax claims. Bankruptcy can also stop foreclosure and repossession.

Consumer debt

Nondischargeable consumer debt includes court-ordered alimony and child support, as well as any debt due to obtaining money, property or services by fraud or false pretenses.

Credit card charges for foods and services of more than $500 made within 90 days of bankruptcy, and cash advances of more than $750 within 70 days of bankruptcy, are not dischargeable. Car loans are subject to full repayment.

What about possessions?

A new section, 522 (f)(4), limits the nonpossessory, non-purchase money secured interest in household goods that can be avoided under section 521(f)(1)(B). The definition limits electronic equipment to one radio, one TV, one VCR and one personal computer with related equipment. It excludes works of art not created by the debtor (or a relative) and jewelry worth more than $500 (except wedding rings). Section 523(a)(8) is amended to make student loans dischargeable, in the absence of undue hardship, regardless if they are from nongovernmental and profit-making organizations.

In Virginia, bankruptcy law allows an individual to keep clothes worth up to $1,000, household goods worth up to $5,000, car equity up to $2,000, and cash or debtor’s choice of valuables up to $5,000. Clothing and household goods can be valued at thrift value. If the debtor has something of value over $5,000, the courts will normally sell the asset to pay off the debts.

Retirement and insurance investments

Protected funds include traditional and Roth IRAs (exempted for the first $1 million and indexed for inflation). The exemption amount is unlimited for employee retirement plans, SEPs and SIMPLE IRAs. But debtor beware! Employer retirement funds do not keep exempt status if they are rolled into an IRA. However, if IRAs are rolled into employer retirement funds, the exemption amount is unlimited.2

The Bankruptcy Abuse Prevention and Consumer Protection Act introduced a new exclusion under section 541(b)(7) that applies to employee contributions to ERISA-qualified retirement plans, tax-deferred annuities, and health insurance plans. Exclusions from estate property are given to 529 plans and Coverdell education savings. All contributions to plans made within a year of filing bankruptcy are not protected, and any contributions of one to two years are protected up to $5,000 per beneficiary for a child, grandchild, step-child, grand-stepchild and, in some cases, a foster child.3

The federal exemptions for debtors serve as the “default” set of exemptions. However, individual states have the right to elect out of the federal exemptions and use their own list of state exemptions instead. The federal exemptions apply if the state is silent. Section 522(b)(3) specifies the state or local law governing the debtor’s exemption as the law of the place where the debtor’s domicile was located for the 730 days before filing.

Other considerations

Detrimental aspects of filing bankruptcy include the stigma, and the negative affect on the debtor’s credit rating. The debtor may be ineligible for some jobs, such as those in banking and jewelry industries or jobs requiring bonding.

In essence, a person in bankruptcy is escaping the responsibility for money owed. Under the Fair Credit Reporting Act, a record of the bankruptcy stays on the individual’s report for up to 10 years.

The bankruptcy rules are complex, and every debtor can have unique circumstances, so it is important to seek qualified counsel.   

1. King, Morgan D., “Bankruptcy Reform Limits, But Does Not Eliminate, Ability to Discharge Delinquent Taxes in Bankruptcy,” Journal of Tax Practice & Procedure, June–July 2005.
2. This strategy has not been tested in courts and could be questionable.
3. Kitces, Michael E., “Retirement Accounts and the Bankrupty Act of 2005: Simplification, the Old Rules and the New Rules,” Journal of Retirement Planning, July–August 2005.

Maxine Magri is a CPA in Harrisonburg specializing in consulting and taxation. Contact her at maxine.magri@magricpa.com.