5 Things you should know about Tax Debts in Bankruptcy

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Every year over a million Americans file for Bankruptcy. Bankruptcy is a legal process afforded by the US Justice System to provide you a debt relief if you find yourself in financial distress and are unable to keep afloat.

There are two main categories of bankruptcies: Business bankruptcy (Chapter 11) and Personal bankruptcy (Chapter 7, Chapter 13). Our discussion in this post will pertain only to Personal Bankruptcy. This post in no way substitutes or imparts any legal advice on bankruptcy. You may want to consult an experience Bankruptcy Attorney in your area, for more information on bankruptcy. There are many resources on the internet on the Bankruptcy topic, however, I would recommend Bankruptcy 711-a New York Bankruptcy Attorney website–a very good read on bankruptcy topics.

Here are the 5 things you should know about taxes and its effect on Bankruptcy:

Know the types of tax debts before you file for bankruptcy

  • There are various types of Tax Debts, and not all of them are dischargeable in Bankruptcy.
  • Upon bankruptcy filing, the IRS becomes a creditor, and would file a proof of claim for the taxes it has assessed against you.
  • Having some basic knowledge of how taxes will work when in bankruptcy, will help you make the right decisions.

Most Income Taxes can be discharged (forgiven) in Bankruptcy

Most Income Taxes can be discharged by filing a bankruptcy. However, in order for tax debts to be dischargeable under bankruptcy, certain filing requirements and filing time periods have to be complied with.

Following tax debts cannot be discharged:

  • Taxes for which no return was filed.
  • Taxes for which a return was filed late after 2 years before the bankruptcy petition was filed.
  • Taxes for which a fraudulent return was filed.
  • Taxes that were willfully attempted to evade or defeat.

Certain rules apply to Tax Debt discharge in Bankruptcy

Following rules apply for a successful tax debt discharge in bankruptcy:

  • Income tax debt must be related to a tax return that was due at least 3 years before the debtor files for bankruptcy.
  • The IRS must assess the tax at least 240 days before the taxpayer files for bankruptcy. This assessment may be from taxes reported by you, an IRS final determination in an audit, or an IRS proposed assessment which has become final.
  • As discussed above, taxes reported on a return should not be fraudulent, or as a result of a willful attempt to evade or cheat on taxes.
  • Certain taxes such as withholding taxes which the debtor, in any capacity was responsible for generally cannot be discharged.
  • Tax Penalties are usually dischargeable unless the event that gave rise to the penalty occurred within 3 years of the bankruptcy and the penalty relates to a tax that is not discharged.

”Cancelled Debt” is taxable income and some of it can be discharged in Bankruptcy

When a creditor forgives a portion of a debt you may owe, it is referred to as “Cancelled Debt”. IRS considers the portion of cancelled debt as income for tax purposes. So for example:

If you owed $500,000 to Bank of America, and if Bank of America decides to forgive $300,000 provided you pay back the $200,000, IRS would consider the cancelled debt of $300,000 as an income to you for that year.

In the event that the amount forgiven is $600 or more, the you will receive a Form 1099-C, Cancellation of Debt, from the lender who forgives the debt which will be filed with your tax return that year.

In bankruptcy, you may not have to report the entire amount of canceled debt as income, and hence IRS won’t tax that amount and it will be discharged in bankruptcy. However following four things are notable:

  • The debt-cancellation should approved by a bankruptcy judge court order.
  • The difference between your liabilities and fair market value of your assets immediately before the debt cancellation will not be considered as taxable income and will be dischargeable in bankruptcy. Any additional amount of debt cancelled over this difference will be considered taxable income, and non-dischargeable in bankruptcy.
    Please note that IRS will not take into account any exemptions usually afforded in a bankruptcy process when calculating your assets. So your assets would be calculated without exemptions such as household goods. Also, your retirement savings which are exempt in bankruptcy will be considered as asset by the IRS for asset calculation.
  • The canceled debt which qualified farm-debt is not taxable.
  • Cancellation of debt from the foreclosure of a primary residence is not taxable. This includes debts incurred in refinancing such a debt. However, a second mortgage used to go on vacation, purchase a car, or pay off credit cards would not qualify.

Tax Liens may or may not be discharged in Bankruptcy

A bankruptcy filing may relieve the debtor from paying off the debt obligation, however when it comes to liens it is a different story. Liens filed against the debtor’s property are not dischargeable under bankruptcy.

If you have taxes past-due, IRS will file a Notice of Federal Tax Lien (NFTL) against any property you own, e.g. your residence, car or even an investment-property.

If IRS has failed to file a NFTL before bankruptcy filing, the court will remove NFTL from your property, even if that property is exempted from bankruptcy. However, if the NFTL was filed prior to filing, it will survive the bankruptcy.

However, if the NFTL arises due to tax assessed during bankruptcy, it may not be removed from the property upon discharge if the property was exempted from bankruptcy, even if a Notice of Federal Tax Lien was not filed.

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