Bankruptcy Rules: How the CARES Act is Helping

Most people are familiar with the CARES Act thanks to the economic stimulus payments sent to Americans nationwide. Bankruptcy laws were also temporarily adjusted—a crucial measure especially helpful to those dealing with ongoing unemployment.

The CARES Act, a $2 trillion economic stimulus bill, was passed in March 2020 in response to the health and economic impacts of COVID-19. Many Americans are familiar with this act due to the economic stimulus payments that were sent nationwide. Yet it also contains several lesser known provisions that help support individuals and small businesses.

The CARES Act provides short-term relief to individual debtors under Chapter 7 and Chapter 13 of the Bankruptcy Code. There were also several changes to Chapter 11 reorganizations of small business debtors. See how the rules have changed and what the tax impact could mean for you.

Stimulus Payments Excluded from Income Calculations

Some forms of bankruptcy might require you to collect and sell all excess assets to pay your creditors (Chapter 7). Others might involve a monthly payment plan (Chapter 13) to settle your debts while you retain assets. Either way, your monthly income will be calculated as part of the bankruptcy process.

The CARES Act specifically excludes economic stimulus payments from calculations of your monthly income. These were intended to be one-time payments (although they may be repeated moving forward) and are not representative of recurring, monthly income.

Extending Chapter 13 Payment Plans

Chapter 13 bankruptcy requires debtors to pay off their creditors through a monthly payment plan determined by the bankruptcy court. Losing your job or having your hours cut because of the pandemic could cause you to miss these payments. And missing payments can lead to your case being thrown out.

The CARES Act changed Chapter 13 bankruptcy rules by extending these plans from three to five years to up to seven years. This is provided you can show “material financial hardship” suffered directly or indirectly due to COVID-19. Although no specific rules define material financial hardship, job loss in this uncertain economic climate likely qualifies.

If you’re affected by the coronavirus pandemic and can’t make timely payments, talk to your attorney and accountant for help. You could qualify for the Chapter 13 bankruptcy extension.

Small Business Bankruptcy Provisions

The CARES Act also put provisions in place for small business bankruptcy rules. One such provision amends the Small Business Reorganization Act of 2019 to expand protections for small business owners filing for bankruptcy.

Under the original law, small businesses could apply for Chapter 7 bankruptcy, (which requires liquidation) or Chapter 11 reorganization (which does not). The amendment introduces a third option for small businesses. If an owner is under $7,500,000 in debt (up from $2,725,625 in debt in the original act), they can operate as a “small business debtor.”

This arrangement is a hybrid between Chapters 7 and 11. The business still operates as a debtor-in-possession, but a trustee is appointed to oversee the reorganization plan. The overall process is far more streamlined than a normal Chapter 11 reorganization; it’s also harder for creditors to contest the plan. However, at least half of the debt must be accrued from normal business activities (excluding debts owed to affiliates or insiders). Additionally, the debtor’s principal activity cannot be a single-asset real estate operation.

The goal is to help more small business owners experiencing financial hardship due to COVID-19—and in turn save jobs. Those who are interested in filing for bankruptcy have until March 27, 2021 to file their claim under the SBRA.

Tax Implications of Filing for Bankruptcy

How does all this affect your tax picture? For starters, the discharge of your debt may be taxable as Cancellation of Debt Income. If you receive a million-dollar discount on your debts before they’re discharged, the IRS may consider that million dollars part of your income and tax you on it—even if you don’t have the ability to pay.

Plenty of other “tax traps” might apply when you’re filing for bankruptcy under the SBRA. The best thing you can do as a small business owner or consumer debtor is talk to your accountant and attorney to see what can be done. CARES Act relief may be available; the key is to explore your options with trusted professionals.

Unless the CARES Act is renewed, these changes in bankruptcy rules will expire on March 27, 2021. In the meantime, contact a qualified CPA if you’re experiencing economic hardship. Even if you aren’t filing for bankruptcy, we can help you and your small business weather this storm.

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