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Effect of Bankruptcy on Tax Debts

Every year over a million Americans file for Bankruptcy. Bankruptcy is a legal process afforded by the US Justice system to provide a form of debt relief to the debtor. Bankruptcy process can be of many different types including Chapter 7, Chapter 13, Chapter 11 etc. You may want to consult an experience Bankruptcy Attorney in your area, for more information on Bankruptcy.

There are various types of Tax Debts, and not all of them are dischargeable under Bankruptcy Code. In an event of a bankruptcy fling, the IRS becomes a creditor, and would file a proof of claim for the taxes it has assessed against the debtor. It is important to understand how taxes are handled in a bankruptcy, and hence, having some basic knowledge can help you understand how your tax situation will work under bankruptcy.

Which Tax Debts can be discharged under bankruptcy?

Most of the Income Taxes can be discharged by filing a bankruptcy. However, in order for tax debts to be dischargeable under bankruptcy, they have to comply with certain filing requirements, and filing time periods. The way tax debts are discharged will depend on the type of tax debt, as well as the type of bankruptcy process. In general, the following tax debts cannot be discharged:

  • Taxes not complying with the conditions mentioned below
  • 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 the debtor willfully attempted to evade or defeat

Rules for a Tax Debts discharge under bankruptcy

Following rules apply for a successful tax debt discharge under bankruptcy.

  • Income Tax debt must be related to a tax return that was due at least three 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 the debtor, 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

Tax Debt Cancellation in bankruptcy

In many instances, a taxpayer who has borrowed money might be able to cancel part of his debt through debt-negotiation or in bankruptcy. In bankruptcy, especially Chapter 7, most of the unsecured debts are dischargeable in full.

IRS considers the portion of cancelled debt as income for tax purposes. So for example, if the taxpayer owed $500,000 to Bank of America, and if Bank of America decides to forgive $300,000 provided the taxpayer pays back the $200,000, IRS would consider the cancelled debt of $300,000 as an income to the taxpayer for that year.

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

The taxpayer debtor who has filed for bankruptcy may not have to report the entire amount of canceled debt as income. However following exclusions may apply:

  • The cancellation takes place in a bankruptcy case under the Bankruptcy Code
  • The cancellation takes place when the debtor is unable to pay off the cancelled debt, and the amount excluded is not more than the amount by which the debtor is unable to pay
  • The canceled debt is qualified farm-debt
  • The canceled debt is qualified real property business

Notice of Federal Tax Lien (NFTL) 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. Usually liens filed against the debtor’s property are not dischargeable under bankruptcy. Usually, when a taxpayer has taxes past-due, IRS will file a Notice of Federal Tax Lien (NFTL) against any property the taxpayer owns, so this could be his personal residence, a car or even an investment-property.

Upon bankruptcy filing, the taxpayer debtor under the Bankruptcy Code would be allowed to keep certain property exempted from creditors, i.e. the exempted portion would not be used to pay off his debt owed to creditors.

If IRS has failed to file a NFTL before the bankruptcy petition was filed, the tax lien will generally be removed from the debtor’s pre-bankruptcy property as a result of the bankruptcy, even if the debtor exempted the property out of the bankruptcy estate.

However, a tax lien that arises when a tax is assessed may not be removed from the property upon discharge if the property was excluded from the bankruptcy estate, even if a Notice of Federal Tax Lien was not filed.

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