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Are Bankruptcy Payments Tax Deductible

8 min read
Philip Ahn, Attorney

by Philip Ahn, Attorney

Bankruptcy and taxes are two words that most Americans prefer to stay away from. Nonetheless, taxes are necessary, and more than 1 million people file bankruptcy each year. With this in mind, it makes sense to ask, “Are bankruptcy payments tax deductible?” 

Whether or not bankruptcy payments are tax deductible depends on the Chapter you file, and what types of debts you’ve accrued. Those filing Chapter 13 are often eligible for some deductions, even if a trustee makes payments. Examples of potential deductions include mortgage interest, certain taxes, and business expenses. 

Handling your taxes while going through bankruptcy can be a complicated process to navigate alone. We can connect you with a reputable tax professional and bankruptcy lawyer in your local area before moving forward on your own. 

Learn more about bankruptcy payments and tax deductions below. 

Income Tax and Bankruptcy

The overall tax implications of filing bankruptcy depend on the type of bankruptcy filed and whether or not payments made by the trustee are eligible for tax deductions. Tax issues are often encountered by debtors when filing Chapter 7, Chapter 11, or Chapter 13 bankruptcy. 

The goal of bankruptcy is to give debtors a fresh start. While the Internal Revenue Code (IRC) and the Bankruptcy Code work together to determine tax liabilities and deductions, the IRS is not particularly concerned with offering a fresh start in most cases. 

With this in mind, tax liens are usually considered a “secured debt” that must be repaid regardless of the Chapter filed. It’s important to remember, you must verify all discharged debts with the IRS to ensure they won’t be included in taxable income. 

Generally, tax exclusions can only be invoked if the debt-discharge is approved in your bankruptcy case. 

Learn more about each type of bankruptcy and the potential tax implications of each below. 

Chapter 7 Taxes and Tax Return Requirements 

When filing Chapter 7, a separately taxed bankruptcy estate is formed. The estate consists of the property and assets formerly owned by the debtor. A court-appointed trustee administers it. The bankruptcy estate can incur it’s own income and expenses during the bankruptcy process. 

When the bankruptcy estate is created, the trustee is responsible for calculating, filing, and paying any potential tax burdens on the estate during the bankruptcy process. This includes federal and state income taxes. 

Since the estate no longer belongs to the individual filing Chapter 13, any potential deductions incurred by the property included in the bankruptcy are reserved for the trustee and estate. 

Chapter 13 Taxes and Deductions 

Unlike Chapter 7, Chapter 13 doesn’t require the creation of a separate bankruptcy estate. Since it is a “repayment” bankruptcy instead of a “liquidation” bankruptcy, the debtor still owns property within the estate. There are certain deductions that debtors may be eligible for in Chapter 13; they include:

  • Mortgage Interest: Delinquent mortgage payments are typically mostly interest. In many cases, those interest payments are tax deductible. 
  • Some Taxes: If your repayment plan includes certain taxes like property taxes, those payments are often deductible. These deductions can sometimes include state income taxes paid by the trustee. 
  • Business Expenses: Individuals operating a business in Chapter 13 or those who owned one before filing will likely incur business expenses such as leases, sales taxes, vendor debts, etc. These business expenses can often be deducted on your taxes. 

Chapter 11 Tax Consequences

Chapter 11, also referred to as a “reorganization,” is mainly used by incorporated businesses. However, people who have debts exceeding the maximum limit in Chapter 13 sometimes file Chapter 11 as well. 

Similar to Chapter 7, property within Chapter 11 is placed in a bankruptcy estate. However, the debtor typically becomes the “debtor in possession.” This means they are responsible for paying all taxes related to the estate (usually with the oversight of a trustee). 

They are also eligible for all applicable tax deductions incurred by the payments, such as mortgage interest, specific taxes, and business expenses, but they must also pay taxes on the property they possess. 

When Can a Bankruptcy Filing Be Categorized as Business Related?

The IRS and Bankruptcy Code recognize individuals as two parts: The first is personal, the second seeks profit through business or producing income. Typical and necessary expenses associated with running a business or seeking profits in some other way can be deductible. 

However, you are not allowed to include personal expenses or actions related to your personal well-being in deductions. The business vs. personal distinction encompasses costs related to bankruptcy, such as legal fees. However, expenses must be connected to business activities. 

While the rules are clear, it can be challenging to distinguish between business and personal expenses without a bankruptcy lawyer’s help. The law does help to make the difference more clear via the Origin-of-the-Claim Doctrine. 

What is the Origin-of-the-Claim Doctrine? 

The Supreme Court has helped taxpayers and the law differentiate between personal expenses and business expenses by making it clear in the Kornhauser, Deputy v. du Pont ruling. In this case, the courts essentially ruled that 

“personally paid legal expenses are deductible if the action against a debtor is directly related to operating a business.” 

After this ruling, a “directly connected” test was created to ensure those claiming deductions after bankruptcy were eligible. 

Are Trustee Payments Tax Deductible?

In Chapter 13 and Chapter 11, some trustee payments can potentially be deducted when filing taxes. It’s in your best interest to consult with a proven bankruptcy tax professional and lawyer to learn what deductions you are eligible for. 

Are Bankruptcy Legal Fees Deductible?

Legal fees for bankruptcy can quickly become expensive. In some cases, the IRS and Bankruptcy Code allow for deductions of specific legal expenses. While most legal fees can’t be deducted, there are a few deductions available that could impact you. 

The IRS allows taxpayers to deduct legal expenditures under some circumstances. Individuals can typically deduct legal fees “related to the creation of taxable income.” However,  people filing bankruptcy can’t deduct legal fees related to personal matters or fees that don’t help produce taxable income. 

For the most part, legal fees related to personal bankruptcy are not tax-deductible. This is because they are a personal expense that does not contribute to the production of taxable income. 

Legal Fees For Tax Advice

In general, you can deduct any legal fees related to the production of taxable income, tax-related legal work, and fees paid to an attorney representing you during an audit. 

You can also deduct legal fees related to tax advice (which could coincide with bankruptcy law in some cases). Essentially, if you consult with a bankruptcy lawyer about the tax implications of your bankruptcy, you can deduct the attorney’s fees for that specific work on your tax return. 

How Can I Determine Deductible Amounts? 

If you are filing Chapter 13, you claim available deductions the same way you would any other deductions. If you claim deductions for legal fees paid regarding tax advice, you must file a miscellaneous deduction on your individual tax return. 

It’s important to note that you can’t claim miscellaneous deductions unless they meet the IRS’s “2 percent rule.” The rule means that your total miscellaneous deductions must equal at least two percent of your adjusted gross income before you are eligible to claim it as a deduction. 

If your miscellaneous deductions’ total value falls below two percent, you can’t expense your tax advice-related legal fees. 

Can You Discharge IRS Debts in Bankruptcy?

In general, taxes are considered a form of “secured debt” that must be repaid in part or full. In some instances, filing for bankruptcy can reduce or eradicate the taxes you owe. This can include both federal and state taxes. Precisely what happens to tax liabilities when you file bankruptcy depends on the Chapter you file, your financial situation, and your recent tax-filing history. 

In Chapter 13, your repayment plan can include certain tax debts. If they are included, the rest of your tax debt may be discharged once you make the agreed-upon payments.

In Chapter 7 bankruptcy, tax debts can be discharged if you meet specific criteria. They include:

  • You only owe income taxes
  • You’ve filed a tax return within the two years before filing bankruptcy
  • Your tax debt is more than three years old
  • Your tax debt was assessed at least 240 days before filing bankruptcy
  • You were not involved in tax evasion or fraudulent activities 

It should be noted that bankruptcies do not clear previously recorded tax liens. While bankruptcy can stop the IRS from garnishing wages or your bank account, it does not stop actions from tax liens recorded before you file bankruptcy. 

Should I Hire a Bankruptcy Lawyer?

Bankruptcy is already complicated enough. Determining tax liabilities and deductions without the help of a bankruptcy lawyer is not recommended. If you make a mistake with your filing, it could lead to negative consequences. 

It is also advisable to consult with a bankruptcy tax professional to help you sort out tax obligations, deductions, and implications when filing bankruptcy. 

Unbundled Legal Help Can Help You Get Started on Your Bankruptcy Today

Most bankruptcy lawyers require an upfront payment of their bankruptcy fees before working on your case. If you are searching for an immediate debt-relief solution but don’t have enough cash to pay your lawyer up front, this could pose a major issue.

With Access Legal, our lawyers offer affordable and flexible pay-as-you-go bankruptcy services that allow them to get started on your case immediately. 

Our attorneys also offer virtual consultations so that you can start the bankruptcy process from the comfort and safety of your home. 

Ready to begin the journey to a fresh financial start? Click here to receive a free consultation with an Access Legal bankruptcy lawyer that provides pay-as-you-go bankruptcy services in your local area. 

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