Dealing with the IRS

Bankruptcy does not keep the taxman away. 

When an individual, a partnership, or a corporation is engaged in a bankruptcy, they still must continue to file federal and state tax returns. Additionally, the bankruptcy estate itself is a separate entity and must file a tax return. The bankrupt party files its tax return in the normal manner. When a trustee is appointed for the bankruptcy estate, it is the trustee's duty to see that the bankruptcy estate's tax return is filed.

A bankruptcy filing does have certain tax consequences for both debtors and creditors. When an individual's debts are discharged in whole or part, this may create income to the debtor, which is subject to both federal and state income tax. As a general rule, a discharge of debts will create income. However, this rule only applies to the extent it renders the debtor solvent.

For example, assume that Don, a debtor, has received a $100,000 discharge of debts. Under normal federal income tax rules the discharge creates $100,000 of income. The reasoning here is that Don is $100,000 better off economically even though he received no cash. If Don is insolvent both before and after the discharge, the tax law provides that he will recognize no income. On the other hand, if he is rendered solvent by $10,000 by the discharge, then he will have $10,000 of income in the eyes of the IRS.

When an individual or a business operates a business at a loss, it may create a "net operating loss" that may, in effect, create a deduction that may be taken in another tax year. Net operating losses, can create tax refunds in the future, but also currently because they can be carried back to prior tax years by filing an amended tax return. Because of the availability of net operating losses, and the availability of possible refunds, tax planning becomes an essential element in any bankruptcy.

Income Taxes

Somewhat surprisingly, some taxes are dischargeable in bankruptcy. Trust fund taxes, like social security taxes and unemployment taxes withheld by employers, are non dischargeable. Taxes secured by a valid tax lien are a priority claim and likely to be paid. Taxes not secured by a tax lien are lower priority claims but still are entitled to priority over many other types of claims. Stale taxes, which are taxes older than three years, are not entitled to such priority and are likely not to be paid in bankruptcy, although they are not technically discharged by the bankruptcy. Filing for bankruptcy does not relieve a debtor of the responsibility of filing an income tax return.

When taxes are not paid, tax authorities can impose a tax lien on property of the debtor. A tax lien is the right of a taxing authority to attach and levy against specific property. The federal government levies tax liens as do state and local governments. Tax liens will have priority in bankruptcy only if they predate the bankruptcy filing.