The economy is doing well and may even boom if proposed tax changes are enacted. Nonetheless, a business may suffer reverses and need to file for bankruptcy. In 2017, many famous retailers sought bankruptcy protection, including The Limited, Wet Seal, Hhgregg, Radio Shack, Gymboree, and Toys R Us.
The “b” word isn’t pleasant but may be a fact of life for some businesses. Under one bankruptcy scenario (Chapter 7 for corporations, partnerships, and individuals), the business liquidates its assets, pays off creditors to the extent possible, and goes out of business. Under the other, more common, scenario (Chapters 13 for individuals; Chapter 11 for corporations and partnerships; Chapter 12 for family farms), there’s a reorganization where a plan of bankruptcy is designed to keep the business afloat. It is used to muster the business’s assets and pay off creditors under the terms of the plan, resuming operations with a clean slate.
Bankruptcy and the IRS
How does bankruptcy impact taxes?
Rules for Individuals Also Apply to Sole Proprietorships
Under the bankruptcy rules, there’s no special treatment for sole proprietorships. Owners use the rules for individuals. Any of the rules discussed below for individuals applies to sole proprietorships.
Income Returns Must Continue to be Filed
Income tax returns must continue to be filed even though a petition in bankruptcy has been submitted to a court. The party responsible for filing a tax return depends on the type of bankruptcy:
- For individuals under Chapters 12 (for family farms) or Chapter 13 (individuals): the individual continues to file the annual income tax return.
- For businesses under Chapter 11: the business continues to file the annual income tax return.
- For individuals and businesses under Chapter 7: a new taxpayer—the bankruptcy estate—comes into existence and the trustee in bankruptcy appointed by the court files the income tax return.
Debtor’s Earnings Are Still Taxable
A debtor’s earnings from the performance of services after filing a petition for bankruptcy are still subject to self-employment tax.
Bankruptcy Does Not Equal Tax Forgiveness
Filing for bankruptcy is not an automatic escape route for outstanding federal taxes. In some situations, it may be possible to receive a discharge of tax debt, allowing owners to avoid any personal liability. However, there are nondischargeable tax debts (e.g., taxes that have been assessed within 240 days of the filing for bankruptcy), and there is no relief for debt incurred to pay nondischargeable tax debts.
Retirement Plans Must be Protected
When a business goes into bankruptcy, special rules govern what the company must do with respect to its 401(k) or other qualified retirement plan. Employees should know that the funds already in the plan, which is separate from the company, are protected. However, employer contributions aren’t likely to continue, at least for some time. And for pension plans, it may well be that the full amount of expected benefits won’t be there, although there is government protection for minimum payouts from the Pension Benefit Guaranty Corporation.
When an individual files for bankruptcy, generally speaking his or her funds in qualified retirement plans and IRAs are protected in bankruptcy. They’re treated as exempt property that creditors can’t get. So, for example, all amounts rolled over from an employer plan to an IRA are protected. However, for contributory IRAs (including Roth IRAs) only amounts up to a dollar limit ($1,283,025 in 2017) are exempt property.
Tax Refunds May Pay Off Creditors
If you receive a tax refund after filing for Chapter 7 bankruptcy, it becomes part of the bankruptcy estate. In bankruptcy reorganizations, the refund may have to be used to pay off creditors.
Net Operating Losses Cannot be Carried Back
A debtor cannot carry back any net operating loss from a tax year ending after the bankruptcy case has begun. Different rules apply to NOLs arising in the bankruptcy estate.
Family Farms Have Special Rules
Under the Family Farmer Bankruptcy Clarification Act of 2017, which was signed into law on October 26, 2017, family farms can sell off part of their assets for a Chapter 12 reorganization without having to treat this as capital gain that gives the IRS a priority claim.
The IRS Can’t Object to a Court-approved Bankruptcy Plan
That’s what a federal district court said in a recent case (Brothers Materials Ltd, DC TX 10/30/17). In the case, two brothers owned a business that filed for a Chapter 11 bankruptcy. The court-approved plan had the brothers contribute property that would be sold to cover administrative expenses, with excess amounts going to creditors. The IRS didn’t object then but it did later when the money was used to pay attorneys. The court said once the plan is confirmed, the IRS can no longer object.
Working Out Debts with Creditors is Another Bankrutpcy Alternative
Bankruptcy may be appropriate in some situations. But an easier and less costly alternative may be to work out debts with creditors. If the IRS is one of those creditors, there are options to consider. For example, the In-Business Trust Fund Express Installment Agreement allows small business to pay off trust fund taxes (withholdings from employees’ wages) over time.
If you are struggling financially, be sure to talk with a CPA or other tax advisor before moving ahead with bankruptcy. For more details about bankruptcy and the IRS, see IRS Publication 908, Bankruptcy Tax Guide.
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This is nice to know. It is nice that every topic is covered even finance. For me, it can get a little technical so I love having guides like this.
A good, simple article on what is a complex topic. I wonder how bankruptcy and insolvency will change throughout 2018.
Thank you for your comment, David. With the recent tax changes, it’s way too early to know how they may impact tax rules related to bankruptcy.
I personally believe that businesses must hire a bankruptcy lawyer, just in case they’ll have trouble paying for their debts and loans because this type of professional will help them decide which chapter to file. Well, it never occurred to me that income tax returns must be continually filed even after the petition. Thank you for also sharing here that receiving a tax refund after filing for chapter 7 will be part of the bankruptcy estate.
It’s good to know that tax refunds can help in paying creditors in the event of a bankruptcy. I’ve been thinking about helping a friend of mine find a bankruptcy attorney because she might need to consult one soon. The profits of her business has been dwindling down each month which makes is all the more impossible to pay off the debts she has incurred in order to keep it afloat.