Taxes When You Go Through Bankruptcy

Bankruptcy is a legal process that allows individuals and businesses to get relief from debts they can't pay. It interacts with the tax system in several important ways, both protecting debtors from certain tax consequences and imposing specific obligations.

One of the most significant tax benefits of bankruptcy is that debts discharged through the bankruptcy process are excluded from cancellation of debt income. Normally, when a creditor forgives a debt you owe, the forgiven amount is taxable income. But if the debt is discharged in a bankruptcy case, it's completely excluded from income — you don't owe tax on the forgiven amount. This is the insolvency exception's stronger cousin: bankruptcy provides an absolute exclusion, while the insolvency exclusion outside bankruptcy is limited to the amount by which you were insolvent.

Whether bankruptcy can eliminate tax debts is more nuanced. Income tax debts can be discharged in Chapter 7 bankruptcy, but only if several strict conditions are met: the tax debt must be for income taxes (not payroll taxes or other types), the return must have been due more than three years before the bankruptcy filing, the return must have been actually filed more than two years before filing, the tax must have been assessed more than 240 days before filing, and there must be no fraud or willful evasion involved. When all these conditions are met, the income tax debt can be wiped out just like credit card debt. Tax debts that don't meet these conditions survive bankruptcy and must still be paid.

When you file for bankruptcy, your non-exempt assets may form part of the bankruptcy estate, which is treated as a separate taxable entity. If the estate sells property with built-in gain, the estate may owe its own tax. Chapter 13 bankruptcy — which involves a repayment plan rather than liquidation — doesn't create a separate taxable estate for income tax purposes, so this complication is primarily a Chapter 7 issue. Tax refunds you're owed when you file may become property of the bankruptcy estate, though a portion attributable to the post-petition portion of the year may remain yours.

If you have a tax debt going into bankruptcy that doesn't meet the discharge requirements, it becomes a priority claim in the bankruptcy and must be paid in full through the repayment plan (Chapter 13) or before other unsecured creditors (Chapter 7). Even if the underlying tax isn't dischargeable, interest and penalties on the tax debt may be dischargeable in bankruptcy, reducing what you ultimately pay. After bankruptcy, staying current on your taxes is essential — the IRS may reinstate collection actions if you fall behind on post-petition tax obligations.