Understand more about Bankruptcy and How it Affects your Income Taxes

Bankruptcy is designed to help honest taxpayers dealing with impossible financial hardship to have their debts legally eliminated, allowing them to make a fresh start in life. Most consumer debt and secured debt can be eliminated in a successful bankruptcy, but as a general rule, government debts are not eliminated. These government debts will include federal and state taxes, government loans, student loans and more. Learn more about different types of bankruptcy you can file. IRS Publication 908 discusses this entire subject in more detail and a summary is presented below.

Those filing for Bankruptcy protection are required to be current with their tax return filings and submit copies of their last three years of tax returns at the time of their bankruptcy filing. A separate legal entity called the “bankruptcy estate” is created with the debtor’s assets and property and the bankruptcy trustee uses the “bankruptcy estate” assets to pay debts in a certain order of priority. These steps are generally handled by your bankruptcy attorney. There are currently ten numbered priorities. First is domestic support, child support and alimony. Second is property taxes, some withholding taxes and administrative expenses. Then come various types of unsecured debt, including credit cards and other unpaid bills. Federal income taxes are considered “eighth priority” on this list, so it is common that little or no money will remain to pay any income taxes still owed by the debtor.

Unpaid taxes from second or eighth priorities are generally not discharged. When the bankruptcy estate is distributed and the bankruptcy case closed, the debtor who still owes taxes now needs to find a way to pay them.

In a chapter 13 repayment case, all debts are discharged, including taxes, when the debtor completes the required repayment plan. The court may allow a “hardship discharge” in a chapter 13 case, terminating the repayment plan when the debtor cannot continue but should not be held responsible. This may result in the discharge of some taxes and other debts. However, if a tax lien was filed before the bankruptcy filing began, that tax is still due and payable. Also any tax liability resulting from fraudulent returns or an intent to evade tax law must be repaid.

In a chapter 7 liquidation case, no discharge of taxes is permitted. Chapter 7 filing assumes the debtor is in such a dire situation that liquidation is the only way out. The debtor already receives a huge benefit by the discharge of their unsecured debt and is not entitled to avoid taxes after the bankruptcy.

Chapter 11 and 12 cases for individuals follow the same tax discharge rules as Chapter 7. These chapters also cover some businesses and set rules for their different circumstances.

Options for these taxpayers include setting up a repayment plan with the IRS, borrowing privately or requesting an Offer in Compromise. These options are available to non-bankruptcy filers as well. Individuals who have trouble paying back taxes after a bankruptcy are strongly encouraged to contact a qualified attorney for proper guidance.