A fundamental component of any bankruptcy consultation is to review the state and federal income tax returns of a prospective client. Bankruptcy law requires that a debtor must be up to date in their income tax filings. Additionally, these returns are required to be submitted to the assigned Bankruptcy Trustee no later than seven days before the debtor’s first court hearing, which is referred to as a Meeting of Creditors or 341 Meeting. The returns will be reviewed, and the debtors will be questioned about their accuracy. However, frequent issues can arise with respect to the income tax returns, which can either prevent or restrict the relief provided by the Bankruptcy Court, or lead to an audit of previous income tax returns. This heightened scrutiny of the accuracy of income tax returns needs to be carefully considered by a prospective debtor, and they need to be forward and candid with the bankruptcy attorney during the initial consultation if there are obvious errors.[i]
Income tax returns are signed under the penalty, so the accuracy of their contents is very important. These are some of the common mistakes that are observed in the tax returns provided in bankruptcy cases: 1) debtors are claiming dependents that are not in the household, or that have not been in the household for the entire 12 months of the preceding year; 2) married couples file separate tax returns, but claim single or head of household status, rather than married filing separately; 3) debtors are claiming business losses for non—existent businesses, or are claiming losses that cannot be substantiated by bank records; 4) debtors are claiming medical expenses or cash/check charitable expenses which are not supported by their financial records; 5) debtors are claiming different addresses or residency on their income tax returns, compared to what they identify in their bankruptcy petition. In the majority of cases, these discrepancies usually lead to the receipt of a refund higher than the amount that the debtor would have been expected to receive if the returns were accurate. In some cases, these errors or omissions are more designed to prevent having to pay income taxes, rather than increase the amount of the refund. While mistakes are always going to be made, a Bankruptcy Trustee is going to closely review and question the debtor under oath about any mistakes that lead to a financial benefit that a tax filer would not have otherwise received.
Many of these errors may not be fatal to a bankruptcy filing, but would probably have to be corrected by amendments prior to the case being filed. In order to receive relief from the bankruptcy court, the debtor’s case must be filed in good faith. Making false statements or misrepresentation to a taxing authority could be considered a lack of good faith, which would result in the loss of any relief from the bankruptcy court. Of course, in the process of the amending the returns, the debtor may be liable for repayment of any refund or tax credit which was overpaid or improperly paid based on the numbers in the original return. And while the debtor may successfully obtain a discharge in their bankruptcy case, they also risk an audit or assessment for previous returns which could generate even greater tax liabilities.
Unfortunately, many individuals rely on friends or family members to prepare their tax returns for them. There are various software platforms available to make it very easy for a person to file an income tax return. The general goal is to generate as large as a refund as possible for the tax-filer. The problem is that many people are relying on the advice of people who are not tax professionals. Additionally, while the tax filer may have received assistance that they believed to be “professional”, the return is designated as “self prepared”. Consequently, the tax-filer, and not the individual who prepared the tax return, is responsible for the accuracy of its contents.
Hiring a tax professional to prepare your income tax returns can be expensive. However, there are circumstances where you should always seek the assistance of an accountant or CPA to assist you in your tax filings: 1)if you operate a business or have any income from self – employment; 2) if you itemize your deductions; 3) if you took a distribution from an IRA, 401(k), or other pension or profit – sharing plan in the relevant tax year; and 4) if there have been any substantial changes in your professional, financial or family situation, such as a marriage, divorce, or job change. The cost of hiring a professional will be more than offset by the peace of mind that you will have knowing that the returns were properly prepared by a tax professional. And if a bankruptcy becomes necessary based on the deterioration of your financial situation, your bankruptcy attorney will know that they can rely on the income tax returns in preparing your bankruptcy petition and representing you in court.
[i] All communications during a bankruptcy consultation are protected by the attorney’s duty of confidentiality, and the attorney is prohibited from revealing such communications to third parties, absent specific circumstances which are not applicable for this article.