How Bankruptcy Impacts Your Taxes

Bankruptcy has always been part of this country’s history, but the face behind who is filing for this protection has evolved over the years.

Our forefathers made bankruptcy a part of our constitution, but back then, debt wasn’t readily available to the working class, so bankruptcy was only used by businesses. But by the end of World War II, debt expanded to citizens and many found solace from their mounting obligations through bankruptcy.

In 2005,the bankruptcy laws were tightened but it can still provide relief for debt including your tax burden. Most overwhelmed debtors rush off to an attorney to file bankruptcy without analyzing the impact on tax liabilities, but it’s important to contact your tax professional to see if the timing is right to file bankruptcy and to see if you will get relief from your tax liabilities.

After all, when it comes to taxes, there are rules.

First of all, if you are under audit, bankruptcy will not stop the audit. It will stop collection action while the bankruptcy is pending and if there is no Relief of Stay motion from the IRS. However, the 10-year statute of limitations is extended for the entire time of the bankruptcy proceeding plus 30 days for administrative time. Any time collection action comes to a halt, such as during the processing of an offer in compromise or during the time you are deemed currently not collectible, the statute is extended. So bear that in mind when considering bankruptcy.

Secondly, not all tax debt can be discharged in bankruptcy. Items considered priority debt cannot be discharged. This includes child support, student loans, drunk driving charges, fines stemming from the commission of a crime and priority tax debts: certain penalties (trust fund penalty), fraud assessments and the trust fund portion of payroll tax debts. Priority debt must be completely repaid in a Chapter 13 reorganization.

For taxes to be dischargeable in bankruptcy, they must be personal income taxes which are at least three years old as counted from the due date of the tax return including extensions. The tax return must have been filed by the taxpayer; it can’t have been a substitute filed return prepared by the IRS. Also, the tax must be assessed at least 240 days. So if you just filed your 2006 tax return, you are not off the hook for the liability in a bankruptcy until 240 days have gone by. And if the IRS has filed a tax lien against your real or personal property, you cannot have equity in that property.

And if you haven’t filed your tax returns, it doesn’t matter how old the liability, those taxes cannot be discharged in bankruptcy.

Forgiveness of debt is normally considered taxable income--but not when it comes to bankruptcy or insolvency. So even if you receive a 1099 from a lender whose debt was discharged in your bankruptcy proceeding, be sure to take it to your tax professional. It can be dealt with on the tax return to keep the IRS off your back. It is not taxable income.

Sometimes it is better to simply present an offer in compromise to settle a tax debt. But it all depends upon the circumstances. Involve your tax professional and attorney to determine which course of action suits your situation.