Bankruptcy proceedings begin with the filing of a petition with the bankruptcy court.
A bankruptcy petition is a request that the debtor obtain some relief from current debts owed. Sometimes the request for relief is a request that many or all debts be extinguished. Sometimes the request for relief is a request that current amounts owed be restructured and a reasonable plan be made in order to allow the debtor a feasible way to repay current debts over time.
The request of the debtor is determined based upon what type of petition the debtor files. An individual debtor seeking complete relief and elimination of current debts owed might file a bankruptcy petition under chapter 7 of the bankruptcy code. However, an individual debtor seeking a new plan allowing a realistic rate and time of repayment might file a bankruptcy petition under chapter 11 of the bankruptcy code. Chapters 9, 12, 13, and 15 also provide avenues for filing a bankruptcy petition, and each provide a different type of relief for a different type of debtor.
The Chapter 7 Bankruptcy Estate and Taxes
Chapter 7 bankruptcy filings are probably the most common, followed by filings under chapters 11 and 13. Not everyone will have a choice about which type of petition to file. This may be because the debtor is an entity rather than an individual, or an individual rather than an entity, or because an individual makes too much money to qualify for a certain filing.
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.
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.
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.
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).