Debts forgiven or reduced in bankruptcy do not count as taxable income. Generally, when a lender dissolves the borrower’s obligation to repay a debt, the amount of that debt becomes income and it is taxed to the person owing the debt. On the other hand, if a debt is canceled under a bankruptcy proceeding under title 11 of the United States Code, the amount canceled is not income. This exclusion applies only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
The tax obligations of the person filing a bankruptcy petition (the debtor) may vary depending on the bankruptcy chapter under which the petition is filed. Also, the canceled debt reduces the amount of other tax benefits the debtor would otherwise be entitled to.
Bankruptcy proceedings begin with the filing of a petition in bankruptcy court. The filing creates the bankruptcy estate which consists of all the assets of the person or entity filing the bankruptcy petition. If the bankruptcy petition is filed by an individual under chapter 7 or 11 of the Bankruptcy Code, the bankruptcy estate gets treated as a separate taxable entity. In case of Chapter 7 filing, the estate is represented by a trustee, who is appointed under the Bankruptcy Code to administer the estate and liquidate any nonexempt assets of the estate. In chapter 11, the debtor often remains in control of the assets as a “debtor-in-possession” and acts as the bankruptcy trustee. The trustee or debtor-in-possession is responsible for preparing and filing the estate’s tax returns and paying its taxes. The debtor is responsible only for filing his / her own returns and paying taxes on income that does not belong to the estate.
The bankruptcy estate is not treated as a separate entity for tax purposes when an individual files a petition under chapter 12 (Adjustment of Debts of a Family Farmer or Fisherman with Regular Annual Income) or 13 (Adjustment of Debts of an Individual with Regular Income) of the Bankruptcy Code. In such cases, the individual should continue to file the same federal income tax returns that were filed prior to the bankruptcy petition.
Not all tax debts are capable of being discharged in bankruptcy. While individual income taxes can be discharged, it is not possible to discharge residential or commercial property taxes, business sales tax, corporate withholding or such other taxes imposed by the IRS.
A tax debt is dischargeable in Chapter 7 and Chapter 13 bankruptcy petitions, if
- The tax debt relates to a tax return that is due at least three years before the taxpayer files for bankruptcy. The due date includes any extensions.
- The tax return is filed at least two years before the taxpayer files for bankruptcy. The time starts from the date the taxpayer actually files the return
- The IRS tax assessment is at least 240 days old.
- The tax return is not fraudulent or frivolous.
- The taxpayer is not guilty of tax evasion.
Tax debts that arise from tax returns that are not filed are not dischargeable. Also, before a Chapter 7 or Chapter 13 bankruptcy can be granted, the bankruptcy petitioner should prove that four previous tax returns have been filed with the IRS. The four previous tax returns must be filed no later than the date of the first creditors’ meeting in a bankruptcy case. Additionally, bankruptcy petitioners should also provide a copy of their most recent tax return to the bankruptcy court.
Debt settlement and taxes are tricky affairs and so it’s always advisable to get expert help. If your bankruptcy is caused by your inability to pay back taxes, it is very important to work closely with the IRS so as to ensure that your problems are not compounded.