Bankruptcy Law Reform: Why 4 Years of Tax Returns?
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.
