Bankruptcy can help an overburdened debtor wipe the slate clean and start over. Except for some debts, that is, which may be difficult or impossible to discharge via bankruptcy.
Personal bankruptcies have declined by nearly half from a recession-inflated peak of 1.5 million in 2010 to 770,000 in 2016, according to a count by the American Bankruptcy Institute. But while an improving economy has helped reduce the incidence of bankruptcy, one thing that hasn't changed is the difficulty of discharging some common kinds of debts.
Unlike Chapter 13 reorganization, in which debts are restructured with new payment plans and perhaps forgiving of some principal, Chapter 7 bankruptcies -- also known as liquidations -- are typically used to wipe debts away and give people a new start.
Money owed for taxes is one of the major types of debts bankruptcy contemplators bankruptcy are concerned about. "That's kind of the biggest question when people come in," says John Woodman, an attorney with Sodoma Law in Charlotte. Unfortunately, Woodman has to tell them that most federal tax debts cannot be wiped out by bankruptcy.
Jeff Sklarz, an attorney with Green & Sklarz in New Haven, Conn., says that's generally true of taxes a business owner deducts from employee paychecks, such as federal income tax and Social Security contributions. State sales taxes are also safe from erasure by bankruptcy.
Personal income taxes, however, may be erasable by bankruptcy subject to specific rules, Sklarz adds. For instance, the tax must have been due at least three years before the date of the bankruptcy petition. The debtor must have actually filed a tax return at least two years prior to seeking bankruptcy. And the debtor can't have filed an amended return or other new assessment of taxes owed for at least 240 days before seeking bankruptcy.
Even when you can't discharge a tax by bankruptcy, you may be able to reduce the amount owed by an offer in compromise. This allows the IRS to accept an amount less than owed if you can't pay through an installment agreement or other means.
"One of the things that we often have to decide between is doing an offer in compromise with the IRS or filing bankruptcy," Sklarz says. "Which is the most effective way of dealing with taxes? If you know the taxes are going to be non dischargeable, that's when you do the offer in compromise."
Student loans represent another common type debt that is generally non-erasable by bankruptcy. Recently, however, there has been some loosening or at least reconsidering of the way student loans are treated in bankruptcy, Sklarz says.
"For years, unless you were effectively dead or in a coma, it's been impossible to get a discharge on student loans," he says. "Now instead of being virtually impossible, it's slightly less than that in some cases."
"Another big debt that's non-dischargeable is a domestic support obligation," Sklarz adds. "If I'm behind on alimony or child support, that's a domestic support obligation that cannot be discharged."
If you are ruled to have obtained a loan fraudulently, such as by using a fake bank statement to get credit, that will generally not be erased by bankruptcy, Woodman says. Also if you obtain luxury goods within 90 days before filing, that could be ruled non-dischargeable. And the bankruptcy court may consider something as seemingly pedestrian as a costly dental implant a luxury item, he warns.
For a debtor considering bankruptcy, it's worth carefully planning the approach. For instance, buying a luxury item or filing a tax return amendment shortly before seeking bankruptcy protection could be a costly mistake.
And even if you do get a debt discharged in bankruptcy court, that may not be the end of it. A debtor who doesn't fulfill requirements such as providing information about additional assets may find the discharge has been revoked and have to pay the debt after all. "Even though you've gotten your discharge, it's important to continue complying with the court orders and requests," Woodman says.
Bankruptcies may be down considerably since the last recessionary peak, but in 2005 filing were even higher, topping 2 million. So while the rules on dischargeable debts have been relatively stable, the number of bankruptcies where they'll be put into play might be rising again before long.
"The Fed has said the interest hikes could come a lot more frequently than in the past," Woodman notes. "It that occurs, you're going to se a lot more potential filings."