May 3, 2010 12:00 am

What Does Bankruptcy Mean to Your Outstanding Tax Bills?

In tough economic times, more people are filing for bankruptcy protection. According to the American Bankruptcy Institute, in 2009 there were more than 1.4 million filings for consumer-type bankruptcies, up about 31% over 2008. There are two types of bankruptcy for individuals (consumers):

  • Chapter 7, commonly referred to as a fresh start, in which assets other than “exempt property” (such as retirement plan benefits, certain equity in a home, and household effects) are sold and distributed to creditors in satisfaction of outstanding debts. The individual gets to start over, although some debts, such as child support, student loans, and certain taxes, are not dischargeable and continue to be owed.
  • Chapter 13, called a wage earner’s plan, in which an individual with a regular income keeps his or her property (exempt and nonexempt) and repays creditors over time under a repayment plan that usually runs for five years or so. At the end of this period, remaining debts, other than those that are nondischargeable, are wiped out.

As a practical matter, in light of changes made by the Bankruptcy Abuse and Consumer Protection Act of 2005, which applies to cases filed on or after October 17, 2005, very few individuals qualify for Chapter 7 and most must resolve their debt issues through Chapter 13. The following explains what types of tax debts can or cannot be discharged in a Chapter 13 proceeding.

Nondischargeable Taxes

When an individual completes a Chapter 13 proceeding, remaining debts can be discharged, including outstanding taxes (explained below). This means any unpaid amounts are effectively wiped out and do not have to be repaid. However, certain taxes continue to be owed. These include:

  • Taxes related to a return that has not been filed
  • Taxes on a return filed late and within two years of filing for bankruptcy
  • Taxes on a fraudulent return
  • Taxes that the individual tried to evade
  • Debts for withheld taxes, such as employment taxes withheld from employee wages. It also includes the 100% penalty on owners or other persons responsible for such withholding.
  • Taxes not listed or scheduled on the bankruptcy petition, unless the IRS learns of the bankruptcy petition in time to file a claim

Interest through the date on which the bankruptcy petition is filed (“prepetition interest”) and after the filing of the petition (“postpetition interest”) on any of these taxes is also nondischargeable. All tax penalties (other than those explained later) remain nondischargeable.

Dischargeable Taxes

Except as listed above, other taxes are dischargeable. When they are, then any interest arising in the prepetition and postpetition period is also dischargeable. Tax penalties for the failure to make timely tax payments and any interest that accrues on such penalties is dischargeable.

Exception for tax liens. If the IRS has already filed a tax lien, this makes the IRS a secure creditor with respect to the taxes subject to the liens. Secured debts are repaid before unsecured debts. Generally, having a tax lien makes the taxes nondischargeable.

Source: ILM 201005029 in Tax Analysts on October 21, 2009

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Tax Glossary

Real property

Land and the buildings on land. Buildings are depreciable.

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