Bankruptcy, Income Tax Refund, News

HEIGHTENED REVIEW OF INCOME TAX RETURNS IN CONSUMER BANKRUPTCY CASES

Since the Bankruptcy Reform of 2005, additional requirements were imposed upon consumer debtors who filed chapter 7 or Chapter 13 bankruptcy. One of those requirements is that debtors must provide their most recent income tax returns to the bankruptcy trustee, before their meeting of creditors. In the Augusta area, the meeting of creditors is traditionally scheduled between 28-40 days after the bankruptcy case is filed. In addition to providing these returns, the debtors must verify under oath that they are up to date in their income tax filings for all prior years. While the Bankruptcy Code does not require that all income taxes must be paid as a condition of seeking relief, it does require that consumer debtors are up to date in both their state and federal income tax filings.

In the Southern District of Georgia, and specifically in the Augusta area, it is customary for the Chapter 13 Trustee to review the state and federal income tax returns of the debtor for the previous year. In a Chapter 7 case, the trustees prefer to review the income tax returns for the two-year period prior to the bankruptcy filing.  The purpose of the income tax review was essentially twofold. First, it was to verify that the debtors were up to date in their filings and accurately disclosed their income. Secondly, the Trustees also wanted to verify the amount of the debtor’s historical income tax refund.

Recently, the Chapter 13 Trustee for the Augusta division has gone beyond the customary review of the income tax returns as set forth above, and sought to verify that information beyond the income and refund amount is correct. In our observations of court hearings in the Augusta area, we have noticed a heightened focus on several specific components of income tax returns. The Trustee’s office wants to make sure that the income, residence/address, and dependent information are consistent with the disclosures made in the process of the bankruptcy filing. It is important to note that both income tax returns, and the bankruptcy petition, are signed under the penalty of perjury. As a result, there can be serious consequences if there are material discrepancies between those documents.

For instance, if the debtor is presently married, and was married during the previous income tax year, the Trustee expects to see a joint income tax return. If the debtor and his or her spouse – or both debtors in a joint filing – have filed individual returns, an explanation will be necessary. A frequent mistake of married debtors in a bankruptcy case is to claim “head of household” on their separate tax returns. Essentially, a married couple has two options when filing their tax returns. They may either designate the return as a joint return, or that the debtors are married, but filing individually. It is not uncommon for a married couple to file separate income tax returns, especially if one spouse would be considered an “innocent spouse” for purposes of the Internal Revenue Service. For instance, one spouse may be liable for an offset of their income tax refund, for previous taxes, past-due child support, or student loan debt. In that instance, it would make sense for the other spouse to file a separate return in order to preserve their refund, or minimize their tax liability. But if both spouses have resided in the same household, then the Trustee will file an objection if one or both claim the head of household exemption.

Our office has also noticed additional review of the dependents which are claimed on the income tax return. The information that is contained on the income tax return is being compared to the information that the debtor has disclosed in their bankruptcy petition. If the debtor has only claimed two dependents on the previous year’s income tax returns, but lists four dependents in their bankruptcy petition, then an explanation will be required. Likewise, if another individual is claiming some of those dependents, an explanation will be required. These are issues that need to be discussed with your bankruptcy attorney prior to filing, to make sure that the consumer’s attempt to fix a debt problem does not yield a greater problem, either inside or outside of the Bankruptcy Court.

Ultimately, a debtor faces multiple problems if their income tax returns and bankruptcy schedules are not consistent. An objection to confirmation in a Chapter 13 case, or objection to discharge in a Chapter 7 case is a possibility. While amending the returns is a recommended option in this circumstance, it may generate income tax liability which can significantly magnify the debtor’s existing financial problems. Additionally, a referral for audit to the appropriate taxing authority is also a possibility. Finally, the criminal consequences for making a false statement on an income tax return or bankruptcy petition cannot be overlooked. Ultimately, protection under the Bankruptcy Code requires that the debtor file in “good faith”, and conflicts between information submitted to the IRS and the Bankruptcy Court could easily lead to a determination that the case was not filed in good faith.  This in turn will result in the dismissed debtor returning unprotected to their creditors, with the refuge of Bankruptcy Court no longer available.