Bankruptcy Abuse and Consumer Protection Act of 2005
Much has been reported in the media about the changes affecting consumers under
the Bankruptcy Abuse and Consumer Protection Act of 2005, which was signed into
law on April 20, 2005.
But there are some tax law changes to consider. Interestingly, many of the changes
can be found in the Bankruptcy Code rather than in the Internal Revenue Code. The
changes become effective on Oct. 17, 2005.
Protection for Some Assets
The new law changes some of the rules regarding the exemption of assets from bankruptcy.
• Qualified retirement plans and Individual Retirement Account (IRAs).
As under prior law, assets in qualified plans are fully protected from the claims
of creditors. The new law clarifies that this protection extends to IRA rollovers
funded with distributions from qualified retirement plans. But the new law limits
protection for funds in IRAs. The maximum amount of exempt funds is $1 million.
This limit will be adjusted for inflation in the future.
Note: The U.S. Supreme Court had ruled that funds in an IRA were exempt
(Rousey v. J.R. Jacoway, SCt, 2005-1 USTC ¶50,258); it did not place any
cap on this exemption nor give any recognition to the bankruptcy law that had been
pending at the time.
• Residences. Florida and Texas had provided unlimited homestead protection
for personal residences, while other states had more modest protection for homes.
The new bankruptcy law provides uniform treatment that overrides the different state
rules. The exemption is now capped at $125,000 if the home was acquired within 3.3
years (1,215 days) of filing for bankruptcy protection. Thus, homes owned prior
to this time continue to enjoy unlimited protection in Florida and Texas.
• Education savings plans. The new law creates for the first time clear
protection for funds in 529 plans [A 529 plan is a state-operated investment plan
that gives families a federal tax-free way to save money for college. Authorized
by Congress in 1996, they are officially known as qualified tuition programs (QTPs),
but commonly referred to as "529 plans," "state 529 plans" or "section 529 plans"
after the section of the Internal Revenue Service (IRS) code that provides the plans'
special tax breaks] and Coverdell education savings accounts [A Coverdell education
savings account (ESA) is a savings account, created under the aegis of the IRS,
as an incentive to help parents and students save for education expenses]. Contributions
made within a year of filing for bankruptcy are not protected. Contributions made
between one and two years of filing are protected only up to $5,000. Older contributions
are fully protected.
• Asset protection trusts. Some states--Alaska, Delaware, Nevada, Rhode
Island and Utah--allow individuals to create self-settled trusts that protect their
assets. The grantor can be both a beneficiary and trustee of these trusts while
blocking creditors from assets held in the trusts. The new law limits the protection
to transfers of property made within 10 years of filing for bankruptcy only if the
transfers were not made with the intent to hinder, delay or defraud creditors, so
protection can be obtained.
Note: These states permit nonresidents to set up asset protection trusts
within their borders, provided that there is a resident trustee. However, it has
not yet been tested whether nonresidents can enjoy the same asset protection as
residents and the bankruptcy law does not clarify this point.
Discharge of Taxes
For some individuals, outstanding taxes, federal, state or local, can be a main
reason for the need for bankruptcy protection. In the past, an individual who used
a Chapter 13 bankruptcy (a repayment plan that generally ran for three years) could
obtain a partial discharge for taxes related to nonfiled returns and certain late
filed returns; whatever was paid to the government during the repayment period was
all the debtor was required to pay.
The new law changes the rules for Chapter 13 bankruptcy. The repayment period is
now five years. And the law specifically provides that back taxes related to nonfiled
or late-filed returns cannot be discharged. This includes interest that accrues
on the taxes after the filing of a bankruptcy petition. And, as under prior law,
the treatment of penalties follows the treatment of the underlying taxes to which
they relate, so penalties may not be discharged either.
The new law continues the opportunity to obtain a discharge of taxes under Chapter
7, which is a straight bankruptcy filing in which the individual can obtain a fresh
start. Discharge applies only to taxes owed on timely filed returns that arose three
years before the filing of a bankruptcy petition; the IRS must have assessed the
tax at least 240 days before the petition and there is no fraud.
But the opportunity to use Chapter 7 has been severely restricted. This type of
filing is restricted to individuals with income below a set limit who cannot afford
to make monthly payments to creditors of at least $100. Thus, only low-income taxpayers
can now qualify for Chapter 7 bankruptcy and obtain a discharge of back taxes.
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