IRS Bankruptcy Information
Many people worry about what the IRS will do regarding a bankruptcy filing. But in most cases, the IRS is subject to the same bankruptcy laws as other creditors. If you owe taxes when you file for bankruptcy, the IRS becomes a creditor and is dealt with as such. 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, taxes owed to the IRS can be discharged during bankruptcy. This requires proof of no tax fraud, proof that tax returns were filed yearly, and the tax owed must be listed as a liability with the bankruptcy filing. Penalties for non-filing, late payment or deposit or late estimated payments can be discharged. Income tax, excise tax and gift tax that's more than three years old and has been listed as deficient by the IRS for 240 days or more also can be discharged.
Debt as Income
If an obligation to a creditor is forgiven or canceled, the amount owed becomes income for IRS purposes. This income then becomes taxable for the current year. Any tax benefits the debtor enjoyed by owing this debt are also reduced or eliminated. Exemptions are made for persons who incurred debt during active military duty or suffered from natural disasters such as hurricanes, flooding or fires where property is completely destroyed.
Exceptions to tax rules can also include the following: the cancellation of student loans if the student is required to work for certain employers; a normally deductible debt is canceled; and the reduction of a debt because of a property sold if the property caused the debt. You can exclude canceled debt from gross income if the cancellation occurs in a bankruptcy case, debts are canceled when the debtor is insolvent, or the canceled debt is a qualified farm debt or real property business debt or principal residential debt.
Tax Filing Rules for Chapter 12 or 13
Under IRS rules, a person, family farm or fisherman filing under Chapters 12 or 13 is required to file yearly income tax as he would normally. When a bankruptcy is filed, a "bankruptcy estate" is created to pay creditors, but this entity does not file separate tax forms. Under Chapter 13, a trust account is set up to pay creditors. This account can accrue interest, but this interest is not taxable and should not be reported by the debtor or the trustee as income.
Tax Filing Rules for Chapter 7 or 11
Under Chapters 7 and 11, the "bankruptcy estate" does become a separate taxed entity and is taxed separately from the debtor. Chapter 7 bankruptcies are represented by a court trustee, who administers and liquidates nonexempt assets of the estate. Chapter 11 allows the debtor to retain control as "debtor-in-possession" and acts as her own trustee. In both chapters, the debtor files a standard 1040 and the estate files a 1041. Joint married bankruptcies under law are administered jointly, but each person involved has an individual "estate," which files a separate 1041 form.
Finding Help
To find help with any of this tax information or to get a more in-depth answer, check with either the IRS or a tax attorney (see Resources). The IRS information can be difficult to understand, so write down any questions you have after looking over the information and ask for clarification for your specific situation from the tax attorney or trustee who is handling your bankruptcy.
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