Christopher S. Mulvaney,

Attorney and Counselor-at-Law

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THIS WEBSITE INCLUDES GENERAL INFORMATION & THE OPINIONS OF CHRISTOPHER S. MULVANEY. IT IS INTENDED TO STIMULATE A BASIS FOR QUESTIONS RELATED TO YOUR PARTICULAR FACTUAL CIRCUMSTANCES — BEFORE YOU ACT.  THIS WEBSITE DOES NOT CONSTITUTE LEGAL ADVICE. IF YOU WANT LEGAL ADVICE, PLEASE MAKE A ZOOM APPOINTMENT TO SPEAK WITH ME.

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Gonzaga University School of Law – Spokane, Washington – Class of 2002 – Cum Laude The Latin phrase “Deo patriae, scientiis, artibus” translates to “For God and country through sciences and arts”.  The initials A.M.D.G. on the seal of Gonzaga Law School stand for Ad Majorem Dei Gloriam, which is Latin for “For the Greater Glory of God” the Motto of the Society of Jesus (Jesuits): a Catholic religious order founded by St. Ignatius of Loyola.

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For a lawyer advising a client on bankruptcy, the most important tax issues to explain include the taxability of discharged debt, the non-dischargeability of certain tax debts, the treatment of capital gains from asset sales, the fate of tax refunds, and the distinction between Chapter 7 and Chapter 13 tax rules. 

Taxability of discharged debt

The central tax benefit of bankruptcy is the exclusion of most forgiven debt from income. 

• Cancellation of debt income (CODI): Outside of bankruptcy, if a creditor cancels or forgives a debt, the debtor must generally include the amount of the forgiven debt as income and pay taxes on it. This often happens with foreclosures or debt settlements.
• The bankruptcy exclusion: Debt discharged in a Title 11 bankruptcy case is not considered taxable income for the debtor. This is a critical advantage of bankruptcy over other forms of debt relief.
• Form 982: If a client receives a Form 1099-C for canceled debt that was discharged in bankruptcy, they should file Form 982 with their tax return. This form notifies the IRS that the debt was canceled in a bankruptcy case and is not taxable. 

Dischargeability of tax debts

Not all tax debts can be eliminated in bankruptcy. The rules are complex and depend on several factors, including the type of tax, how old the debt is, and whether returns were filed. 

• Priority vs. non-priority tax debt: Recent income taxes and payroll taxes are generally considered “priority debts” and are not dischargeable. Older income tax debts may be discharged if they meet certain criteria, such as the tax return being due at least three years before filing for bankruptcy.
• Strict requirements for discharge: To have income tax discharged in a Chapter 7 filing, a client must meet specific criteria regarding the age of the debt, timely filing of tax returns, and assessment timing by the IRS. Fraudulent taxes are never dischargeable.
• Tax liens: A tax lien placed on a debtor’s property before bankruptcy may survive the proceeding, even if the underlying personal tax liability is discharged. 

Asset sales and capital gains

In Chapter 7 bankruptcy, a separate taxable entity called the “bankruptcy estate” is created. This entity holds the debtor’s non-exempt assets and is responsible for any taxes incurred. 

• Sale of assets: The bankruptcy trustee may sell assets to pay creditors. Any gain realized from these sales is taxed to the bankruptcy estate, not the individual debtor. However, the debtor is responsible for any capital gains from the sale of assets they owned after the bankruptcy filing.
• Election to shorten tax year: For a client filing Chapter 7, an election can be made to create two “short” tax years. The tax liability from the first short year becomes a claim against the bankruptcy estate, meaning the trustee, not the debtor, is responsible for paying it. 

Treatment of tax refunds

The timing of a bankruptcy filing can significantly impact a client’s tax refund. 

• Chapter 7: Any portion of a tax refund earned before filing is considered an asset of the bankruptcy estate and can be taken by the trustee to pay creditors. Strategic filing—for example, after receiving and spending the refund—may allow the client to keep it.
• Chapter 13: The tax refund is considered disposable income and may need to be turned over to the trustee each year to help fund the repayment plan. In some cases, a debtor can petition the court to keep a portion of the refund for necessary expenses. 

Differences between Chapter 7 and Chapter 13

The tax implications differ based on the chapter filed.

Chapter 13 (Reorganization): No separate taxable estate is created. The debtor remains responsible for all tax obligations. Priority tax debts must be paid in full through the repayment plan, and all tax returns must be filed on time for four years before filing. 

Chapter 7 (Liquidation): Creates a separate taxable estate for the debtor’s non-exempt assets. The debtor’s tax attributes are passed to the estate, and discharged debt is non-taxable to the individual.

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