How Bankruptcy Affects Your Taxes

You’re at a place where your debts are starting to pile up, and there’s no end in sight. That can feel really overwhelming, and tackling the issue can seem daunting. That’s why bankruptcy exists, and there’s no shame in taking control of your financial wellbeing and charting a clear path forward. 

That said, it isn’t always easy. And there are plenty of moving parts to account for. So unless you’re filing for bankruptcy in Ohio right around tax time, you likely aren’t thinking too much about how bankruptcy affects your taxes. Rest assured, though, that the court and your trustee will be considering how taxes factor in to your case. Whether you expect to get a refund or you owe, and whether you are up-to-date on tax payments or not, there’s a lot to consider when it comes to the wide world of taxes and bankruptcy. Let’s get into it!

Can Bankruptcy Eliminate Tax Debt?

This is one of many common bankruptcy questions. Chapter 7 bankruptcy is often referred to as “liquidation” since it’s a standard part of the process to use all available income and assets to pay down debt. Items may be sold in order to accomplish this, and in the end, you’ll be left with the necessities for life and a clean financial slate. Chapter 13 bankruptcy will set up a repayment plan for a few years into the future. In both cases, debts have been squared and you can now move forward. 

But what about tax debt? Will it also be discharged as part of your bankruptcy case? This could especially be top-of-mind if you happen to be going through a bankruptcy case within tax season and you expect to owe on your filing. In general, tax debt is not dischargeable in any sort of bankruptcy, though there are some key exceptions to that rule. If you are filing a chapter 7 bankruptcy and your tax debt is from three years prior to bankruptcy and the tax assessment is at least 240 days old, there is a possibility that it may be discharged. The tax return would need to have been filed on time and without fraud–debts from unfiled returns cannot be discharged. In chapter 13 bankruptcy, tax debts are typically included in your repayment plan.

In some cases, though, bankruptcy can actually add to tax liabilities, since the trustee may end up selling your assets and you may incur taxable gains or losses. Timing is critical and can play a big role in how much bankruptcy affects your taxes. This is a good place to note that if you benefit from an Earned Income Tax Credit or an Additional Child Tax Credit, these are both exempt from bankruptcy in Ohio.

If, for whatever reason, your tax debt is not eliminated as part of your bankruptcy case, remember that the process will free up available funds by discharging other debts, which should help you to be better equipped to repay tax debt. If needed, the IRS may be open to working on a repayment plan with you. Your Ohio bankruptcy lawyer can help you to determine the best course.

Potential Exceptions

In most bankruptcy cases in Ohio, taxes will not be dischargeable in bankruptcy. That said, there are some exceptions that might allow you to include past tax debt in your bankruptcy filing. If you have experienced fraud, if mistakes were made that led to you owing when you truly did not, or if paying past tax debt poses a provable, undue hardship, you may not have to pay these debts.

Of course, as always, the automatic stay that goes into effect when you file for chapter 7 or chapter 13 bankruptcy will temporarily suspend any collection efforts on the part of the IRS. This buys time to assess your tax debts and see if bankruptcy can help you discharge them, or if they will need to be handled another way. Regardless of whether you can afford to pay your taxes currently or not, it is necessary to file them accurately and on time to prevent future complications and potential penalties.

What Happens to Your Tax Return During Bankruptcy?

A tax return isn’t a gift–it’s part of your annual income. Getting a refund is simply evidence of withholdings that were higher than necessary over the course of the tax year. Viewing it, not as a yearly gift, but as part of your total income, can help to answer this common bankruptcy question.

No one wants to lose money that’s coming their way, and this is especially true of your annual tax refund. If you expect to be receiving a refund and you are also in the midst of bankruptcy proceedings, there are some things you can do to try and retain those funds. And if you foresee  chapter 7 or chapter 13 bankruptcy in your future, but are at the beginning of a tax year, there are steps you can take now to better use available resources.

The first thing to be aware of is any available exemptions allowed when filing for bankruptcy in Ohio. These include housing, a vehicle, work equipment, and some financial assets–the basics you need to keep working and living. The state allows you to keep these things when filing for bankruptcy in Ohio, so they are counted as exemptions in your case. Ohio offers homestead, motor vehicle, personal property, money benefits, and wildcard exemptions. To claim these exemptions when filing for bankruptcy in Ohio, you need to have lived in the state for at least two years. It’s also worth noting that federal exemptions do not apply here–only state exemptions are allowable.

How can exemptions help you to retain your tax refund? The wildcard exemption allows you to keep property or cash that is above and beyond other applicable exemption limits. The personal property already allows you to protect up to $550 of cash that is on hand or deposited with a financial institution. The wildcard exemption gives you an additional $1,475 to claim as an exemption. This can be one way to keep your tax refund. 

Timing is important here as well–tax refunds from the tax year before you file for bankruptcy will be considered as part of your bankruptcy estate and likely used to pay down debts, unless you fit criteria for an exemption or exception. But a tax refund from any time during the tax year that falls after you file for bankruptcy is yours to keep. If you have a little leeway in timing, you can plan appropriately to file for bankruptcy at a time when you can keep the most of your tax refund. Work with your trustee and your bankruptcy attorney to determine your best option.

If you know that you plan to file for bankruptcy in Ohio in the near future, and you are able to adjust your tax withholding to prevent a large tax refund, that might be the better idea. If the refund ends up being very low, a trustee is less likely to see it as worthwhile to seize. This can also free up resources, putting more money back in your paycheck for necessary expenses. If you are able to obtain your refund and use it on everyday needs, like rent, utilities, food, clothing, vehicle maintenance and car payments, medical needs, education or bankruptcy-related costs, that is another option. But using it to pay friends or family any money you may owe them, or to pay a credit card bill, could be cause for the trustee to claim preferential payment, and then work to retrieve that money. Depositing the sum isn’t a guarantee you can keep it either. Using a tax refund for your basic needs and keeping good records to show how you’ve spent it could be your best bet. 

Another thing to remember is that there are big differences between filing for chapter 7 or chapter 13 bankruptcy. Chapter 7 is a “once and done” sort of situation, whereas with a chapter 13 bankruptcy, you are repaying debt over the course of 3 to 5 years. So while with a chapter 7 case the trustee may get their hands on your tax refund once, they could seize it every year during your chapter 13 repayment plan, since it is technically defined as “disposable income.” This is another reason to lower withholdings and limit the size of your tax return. That said, if you’re receiving the money in your regular paychecks instead of once a year, it could still be used to repay debt. Again, a qualifying emergency may be reason enough for you to keep the funds. Work with an experienced chapter 7 bankruptcy lawyer to see which path is best for you, and how to manage a potential tax refund to your best advantage.

Get Your Bankruptcy Questions Answered By A Chapter 7 Bankruptcy Lawyer

If you’re considering filing for chapter 7 or chapter 13 bankruptcy in Ohio and are wondering how bankruptcy will affect your taxes, it’s time to start working with an experienced Ohio bankruptcy lawyer. James Hausen and his skilled team of legal professionals can help you to determine the best course of action while navigating the worlds of taxes and bankruptcy. Give us a call or fill out our online contact form and we will be in touch. Hausen Law is happy to serve all of Northeast Ohio, including the Akron, Canton, Cleveland, Wooster, Dover/New Philadelphia, and Youngstown communities. Contact us today to set up a free consultation.