Bankruptcy proceedings begin with the filing of a petition with the bankruptcy court. The filing of the petitions creates a bankruptcy estate. If the debtor is an individual who files for bankruptcy under chapter 7 or 11, the bankruptcy estate is treated as a new taxable entity, separate from the individual taxpayer.
Tax Obligations Created by Bankruptcy
The tax obligations of the person filing a bankruptcy petition (the debtor) vary depending on the bankruptcy chapter under which the petition was filed.
Generally, when a debt owed to another is canceled the amount canceled or forgiven is considered income that is taxed to the person owing the debt. If a debt is canceled under a bankruptcy proceeding, the amount canceled is not income. However, the canceled debt reduces the amount of other tax benefits the debtor would otherwise be entitled to.
If a husband and wife file a joint bankruptcy petition and their bankruptcy estates are jointly administered, their estates must be treated as two separate entities for tax purposes. Two separate tax returns must be filed (if they separately meet the filing requirements).
Chapter 7 Exemptions
The estate in a chapter 7 case is represented by a trustee. The trustee is appointed under the Bankruptcy Code to administer the estate and liquidate any nonexempt assets of the estate. The bankruptcy trustee sells the nonexempt assets and uses the proceeds of the sale to pay current creditors of the debtor.
Sometimes a debtor will not have any nonexempt assets. Many people filing for bankruptcy only own assets classified as exempt. Under this circumstance, there will be nothing for the bankruptcy trustee to liquidate.
Generally basic necessities qualify as exempt. Small amounts of other property may also qualify as exempt. There are two methods used in Minnesota to determine whether assets are exempt: the federal method and the state method. No one method will provide better protection for everyone.
Chapter 7 Discharge
In a chapter 7 bankruptcy proceeding, after the liquidation process, if any, the dischargeable debts of the debtor are discharged, or wiped out. Any debt classified as non-dischargeable, however, will remain.
Before filing for bankruptcy it is important to determine which assets are dischargeable and which are non-dischargeable. A person who only owes debts that are dischargeable will be in a better position to file a chapter 7 bankruptcy than a person who owes debts that are primarily non-dischargeable. A person with primarily non-dischargeable debts may want to consider a different type of bankruptcy filing, such as a bankruptcy that allows the creation of a new repayment plan.