Tax Implications of Filing for Bankruptcy

Financial disaster can occur at any time and lead a person or business to filing bankruptcy. It’s unfortunate, but it happens.

If you find yourself in this predicament, you should know how the tax code applies to your situation. It’s not cut and dried, but if your timing is right and it’s structured properly, your federal tax liabilities can be discharged in bankruptcy.

Here are the criteria that the IRS outlines for determining whether or not your tax is dischargeable:

  • All tax returns that represent the outstanding debt must have been filed with the IRS, the liability cannot stem from a Substitute Filed Return (SFR) prepared by the IRS;
  • There must not have been fraud or willful evasion involved with the filing of any of the tax returns eligible for discharge;
  • It must be an income tax liability. The trust fund portion of payroll tax liabilities (the withholdings from an employee’s pay) can never be discharged in bankruptcy. Nor can civil penalties associated with failure to file and pay payroll taxes be discharged.

Timing is critical. More than one bankruptcy case has been blown out of the water because these IRS guidelines were not met:

The return was due at least three years ago. The taxes must be from a tax return that was due (including all valid extensions) at least three years before you filed for bankruptcy. For example, if your 2009 income tax return were filed for which extensions to file the return expired on Oct. 15, 2010, the tax return due date test will be satisfied if the bankruptcy petition is filed after Oct. 15, 2013.

You filed the return at least two years ago. Not everyone files on time. You must have filed the tax return at least two years before filing for bankruptcy. To avoid additional objections from the taxing authority, you must make sure the return is signed and mailed or electronically filed, and sufficiently complete to be deemed a tax return. Using the above example, if extensions to file the 2009 return expired on Oct. 15, 2010, you filed the return on April 15, 2012, and you filed for bankruptcy on Oct. 15, 2013, you won't be able to discharge the debts. You will have satisfied the tax return due date test, but not the tax return filing date test. In this scenario, you must wait until two years after April 15, 2012, or until April 15, 2014, to file for bankruptcy.

The taxes were assessed at least 240 days ago. The IRS must have assessed the tax (processed the return and entered the liability in its records) against you at least 240 days before you filed for bankruptcy. Make sure you know the exact assessment date. You can get this information by contacting the IRS.

For individuals, the most common type of bankruptcy is a Chapter 13. The IRS states that before you consider filing a Chapter 13 here are some things you should know:

  • You must file all required tax returns for tax periods ending within four years of your bankruptcy filing;
  • During your bankruptcy you must continue to file, or get an extension of time to file, all required returns;
  • During your bankruptcy case you should pay all current taxes as they come due;
  • Failure to file returns and/or pay current taxes during your bankruptcy may result in your case being dismissed.

Some people are under the misconception that discharged taxes and other debt in a bankruptcy are considered cancellation of debt and therefore taxable. The good news is that they are not taxable income. The IRS will not kick you when you’re down. There is an exclusion for this type of cancellation of debt.

Because different states have different laws, your attorney can advise you as to the rules for discharging your state income tax liabilities.

For more information on this topic see IRS Publication 908.