By Richard K Gustafson II

I recently received an email from someone asking why the new law requires 4 years of income tax returns to file bankruptcy. The emailer also wanted to know if bankruptcy would impact future tax filings.

As for the emailers first question, why 4 years worth of tax returns, I have to confide that I don’t know why Congress thought 4 years of tax returns was somehow more “trustworthy” than 3 years or 2 years of returns. Basically, the reason bankruptcy law requires debtors to provide copies of income tax returns is because the Trustee has a responsibility to the public to enforce the laws and prevent fraud and abuse. Information in tax returns can reveal signs of abuse. I guess Congress figured that a four year look-back time period is sufficient for the Trustee to sufficiently investigate for fraud.

Keep in mind that when someone files for bankruptcy, they are asking the Court to give them financial relief. In exchange for this relief, the Bankruptcy Code and Rules mean to insure that the person asking for relief truly needs relief. Therefore the US Trustee’s Office, a branch of the US Attorney General’s Office, is the government agency charged with the responsibility of protecting the “system” from abusers. Some of the rules the Debtor must agree to when asking for relief under the bankruptcy code includes agreeing to fully disclose all financial information. Providing copies of the tax returns is part of this agreement to disclose financial information.

The second question about whether or not a person loses a tax refund when filing for bankruptcy can only be answered in a fact-specific, personal consultation. A tax refund that someone is entitled to is considered “property of the estate.” In a Chapter 7 case, nonexempt “property of the estate” can be sold by the bankruptcy trustee and the proceeds used to pay creditors. Thus, whether a tax refund could be protected from creditors, or “exempted,” depends on the nature of the refund (is it a refund of overpaid taxes or is it Earned Income Credit), the state’s exemption scheme, and what other assets the debtor has that need to be protected. The short answer is that a tax refund might have to be turned over to the court in a Chapter 7 case to pay creditors, but not necessarily. This is an example of why it is so important to hire competent bankruptcy lawyers to represent you in a bankruptcy case and why you shouldn’t rely on a typing service or your own skills.

The emailers question about “impacting” tax filings also has another dimension to it that I want to touch on. What about discharged debt? Is debt discharged in bankruptcy taxable income? This comes up all the time in talking to debtors. It is true that “voluntarily forgiven” debt such as occurs in a settlement scenario DOES result in tax liability to the person whose debt was forgiven. Thus, if you “settle” with a credit card company and they agree to reduce a $10,000 debt to $7,000 and you agree to pay the $7,000 in a lump sum, you will get a 1099 at the end of the year for $3,000 and would probably have to pay income taxes on that $3,000 of “forgiven debt.” This could increase your taxable income and could even put you in a higher tax bracket.

However, a bankruptcy case does NOT result in tax liability. IRS’ Publication 908 makes it clear that an individual debtor should NOT report discharged debt as income on the debtor’s income tax return for that tax year.

This is important to know because you want to weigh the tax consequences of trying to work out settlements with your creditors into your true cost of settling as compared to filing for bankruptcy. Many people forget or don’t know that there could be tax implications, but there can be.

Anyway, I hope the emailer is satisfied that I’ve fully covered the breadth of the question. While I can’t always give exact black and white answers, this discussion should at least shed some light on some issues raised by the questions. As always, you should consult with a competent lawyer in your state to get answers to your specific situation.

There seems to be a lot of confusion and secrecy about what factors are used to determine one’s credit score. Over the years, many people have asked me about their credit scores and how they are calculated.

I was always able to give these people a general idea about what is considered a positive or negative factor, but wasn’t ever fully aware of all the factors considered and their relative importance.

Typically, a lower credit score equates to a higher risk of an individual defaulting on a loan. Creditors take this risk into account when they set individual interest rates for loans, and they charge a higher interest rate to higher risk borrowers, and vice versa.

The use of credit scores to determine risk is increasing dramatically both by traditional lenders and other types of companies. Potential employers, auto insurance companies, homeowners insurance companies, and mortgage insurance companies are all increasingly using credit scores to determine the rates that they offer to consumers.

I just finished reading a book I recently received from one of Legal Helpers “Bankruptcy Friendly Lenders“, titled “Credit Scores & Credit Reports: How the System Really Works, What You Can Do,” by Evan Hendricks. I found the book to be very informative and would recommend it to anyone who would like to get an in depth understanding of credit reports. I’d like to summarize one of the Chapters that discussed how your credit score is calculated.

There are 5 major factors used, each with a corresponding percentage of importance:

1. Payment History (35%)
a. Track record with various lenders.
b. Length of positive credit history.
c. Length of time that has passed since the most negative item.
d. Severely unpaid debts. (Public Records)
e. Severity and quantity of delinquencies.

2. Amount Owed, Extent of Indebtedness (30%)
a. Quantity of credit accounts.
b. Ratio of credit balance to credit limit.
c. The amount owed on all accounts.
d. How much is owed on each type of account
e. How much of mortgage or other installment loans are paid off.

3. Length of Credit History, The Longer, The Better (15%)
a. Overall Length of Credit History
b. How Long have specific credit accounts been established?
c. How long has it been since you used certain accounts

4. How Much New Credit (10%)
a. How many new accounts, particularly credit card accounts
b. How long has it been since you opened a new account
c. How many recent requests for credit have you made, as indicated by inquiries to the credit bureaus
d. Length of time since credit report inquiries were made by lenders.
e. Whether you have a good recent credit history following past payment problems.

5. Type of Credit (10%)
a. This factor is somewhat unclear, but it measures whether you have a “healthy mix” of installment and revolving credit. Loans from banks are considered positive, while finance company loans are not.

Hopefully this gives everybody a better understanding of the factors considered in calculating their credit scores and you can use this information to rebuild your credit, which should result in a large amount of savings when applying for any new loans.

I would also recommend obtaining your credit reports and reviewing them for inaccuracies. For more information on how to obtain and dispute your credit reports, please see How to Dispute Credit Report Errors in the “Bankruptcy Resource Center” of our website.