Should You Worry About Bankruptcy and the IRS

by Bill on April 13, 2012

Many people worry about what the IRS will do come tax time in regards to their bankruptcy filing. But in most cases the IRS becomes a creditor and is subject to the same bankruptcy law as every other creditor. If you owe taxes when you file bankruptcy the IRS is dealt with under bankruptcy law. Canceled debts are considered income, but certain circumstances can make that income tax-exempt.


Discharged Taxes

If proper guidelines have been followed in filing tax returns, the taxes you owe the IRS can be discharged during bankruptcies. You must prove the following three things:

  • proof of no tax fraud
  • proof of yearly tax filings
  • any tax owed must be listed as a liability with the bankruptcy court

Taxes and fees that can be discharged include:

  • penalties for not filing
  • late payments/deposits
  • late estimated payments
  • income tax, excise tax and gift tax that is more than 36 months and listed as deficient for 240 days by the IRS

Debt as Income

If an obligation to a creditor (other than the IRS) is canceled or forgiven, that amount becomes income to the IRS. The income then becomes taxable for the current year. Whatever tax benefits you had when you owed the debt are reduced or disappear. A few exceptions do exist:

  • if you incurred the debt during active military service
  • if you suffered from natural disasters such as hurricanes, floods or fires and the property is completely destroyed
  • if you are a student and are required to work for certain employers, your student loan may be cancelled
  • normally deductible debts are cancelled
  • if you become insolvent debts may be cancelled
  • if the debt is qualified farm or real property business debt or principal residential debt it may be cancelled

Tax Filing Rules for Bankruptcies

Under IRS rules there are four Chapters within IRS tax law dealing with bankruptcy. Depending on how you approach bankruptcy will determine how the tax laws apply to you. The most common personal bankruptcies are Chapter 7 and 11. While both create a bankruptcy estate Chapter 7 uses a court appointed trustee to liquidate nonexempt items, while Chapter 11 allows you to retain “debtor-in-possession” and manage the estate yourself.

Finding Help

If you are facing both bankruptcy and the IRS you should not handle it completely alone. Check with the IRS or locate a tax attorney. The IRS information can be difficult to understand, so write down any questions you have after looking over the information. Ask for clarification for your specific situation from the tax attorney or trustee handling your bankruptcy. IRS publication 908 covers all tax law regarding the IRS and bankruptcies.

I don’t have all the answers. And by no means try to represent myself as a tax pro; but hopefully this little bit of information helps someone find a general direction and some peace of mind. Anybody with more expertise feel free to chime in.

William Swan, writer

 

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{ 2 comments }

Mhikkai April 16, 2012 at 3:18 pm

Hmm.. I bet only few people knows about this and I am sure they can get additional information from the post too..Anyway, thanks for this..
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Bill April 16, 2012 at 5:01 pm

Hi Mhikkai

I’m hoping this brief post sheds some light on the subject. At least enough to where those who needed it can gain some insight.

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