Divorce Law and You

If you've fallen so far behind on your bills you fear you'll never catch up, or if you find yourself working extra hours just to be able to afford the minimum payments on your debt, you may be considering filing for Chapter 7 or Chapter 13 bankruptcy protection. While bankruptcy may provide you with the fresh start you need, if your existing debt includes money owed to the IRS or your state's tax collection agency, you may find the process more difficult. Read on to learn more about how existing tax debts are treated by the bankruptcy court, as well as whether your discharge of debt will have any implications on your next income tax return.

Can bankruptcy be used to discharge debt owed to the IRS or state revenue agencies?

There are only a few types of debt which are legally prohibited from being discharged in bankruptcy under all but the most extreme circumstances. Both federal and private student loans are generally exempt from discharge in bankruptcy unless you can prove you did not receive the education for which you took out the loans, or that you are permanently and fully disabled and will be unable to ever repay these loans. And, in many cases, tax debts (including past-due taxes, underpayment penalties, late fees, interest, and other assessments) are similarly exempt from discharge.

However, there are some exceptions. Currently, you're able to discharge tax debts if these debts are at least three years old, assessed on income only, and involve no fraud or willful misconduct on your behalf. If you haven't filed a tax return for a specific year, you're not able to discharge tax debt accrued that year (even if your failure to file the tax return or pay taxes for that year was what led to the debt). However, once a return is filed and three years have passed, you may be eligible.

This area of law is not fully settled. A case currently pending before the U.S. Supreme Court involves the issue of whether late-filed taxes are dischargeable in bankruptcy. One appellate court held that a late-filed tax return was not a true "return" that had any legal effect, and this late filing would eliminate the debtor's ability to discharge tax debts through a Chapter 7 bankruptcy, even if all other eligibility criteria were met. The debtors appealed this ruling, and the U.S. Supreme Court is likely to address this issue soon. Until then, it's wise to continue filing prior years' tax returns -- even if late -- if you wish to have related tax debt discharged in bankruptcy

What is the tax treatment of debt discharged in bankruptcy?

Once you've had your debt discharged in bankruptcy, you may be wondering whether you'll owe taxes on this amount as imputed income. Fortunately, any and all debts discharged in bankruptcy are exempt from such provisions -- you'll get a fresh start. Although you may need some professional assistance or advice in filing your first post-bankruptcy tax return to ensure you're not overpaying, going forward, you'll be in the clear.

However, if you've separately negotiated with the IRS or your state revenue agency to reduce the amount of back taxes assessed, or if you were unable to discharge certain tax debts in bankruptcy and pursued other settlement options, you may be required to pay taxes on any difference between the amount originally assessed and the amount you are asked to pay. You'll receive a document from the IRS or your state agency labeled as a 1099-C, or cancellation of debt form. This form should include all the information you're required to provide to the IRS and use to compute the amount of taxes you'll owe.

You may want to consult a bankruptcy attorney like Wade Bettis, J.D., Ph.D., PC for more information or assistance.