Barry Dolowich for the Monterey Herald writes: Question: Unfortunately, I just filed for personal Chapter 7 bankruptcy. I have not filed income tax returns for the last three years because I knew I owed and could not afford to pay. Can I claim my tax debts as liabilities in my filing and avoid paying the taxes using bankruptcy protection?
Answer: Debts are divided into two categories: dischargeable and nondischargeable. Dischargeable debts are those that the debtor is no longer personally liable to pay after the bankruptcy proceedings are concluded. Nondischargeable debts are those that are not canceled because of the bankruptcy proceedings. The debtor remains personally liable for their payment.
As a general rule, there is no discharge for you as an individual debtor at the termination of a bankruptcy case for most taxes, or for taxes for which no return, a late return filed within two years of the filing of the bankruptcy petition, or a fraudulent return was filed. However, claims against you for other taxes predating the bankruptcy petition by more than three years may be discharged. Payroll taxes are fiduciary taxes and are nondischargeable.
Simply, if the income tax debt meets all five of the following rules, then the income tax debt is dischargeable in Chapter 7 and Chapter 13 bankruptcy petitions:
• The due date for filing a tax return is at least three years ago.
• The tax return was filed at least two years ago.
• The tax assessment is at least 240 days old.
• The tax return was not fraudulent.
• The taxpayer is not guilty of tax evasion.
The fact that you may qualify for Chapter 7 bankruptcy protection indicates that you may be a prime candidate to file an "Offer in Compromise" with the IRS to negotiate a palatable deal for the open (not canceled) years along with the unpaid payroll taxes.
If a debt is canceled or forgiven, other than as a gift or bequest, the debtor generally must include the canceled amount in gross income for tax purposes. A debt includes any indebtedness for which the debtor is liable or which attaches to property the debtor holds.
There are several exceptions and exclusions from the inclusion of canceled debt in income. The exceptions include:
1. The cancellation of a student loan for a student required to work for certain employers.
2. The cancellation of debt (accrued mortgage interest) that would have been deductible if paid.
3. The reduction of a debt by the seller of property (foreclosure) if the debt arose from the purchase of the property (nonrecourse debt).
4. The reduction or discharge of debt on a principal residence pursuant to the Mortgage Debt Relief Act of 2007.
The following are "exclusions." You do not include a canceled debt in gross income if any of the following situations apply:
1. The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code.
2. The cancellation takes place when you are insolvent (your liabilities exceed the fair market value of your assets) and the amount excluded is not more than the amount by which you are insolvent.
3. The canceled debt is qualified farm debt (debt incurred in operating a farm).
4. The canceled debt is qualified real property business indebtedness (certain debt connected with business real property).
Generally, the debts, if discharged in bankruptcy, will have no income tax consequence to you. As per the above, you will need to file all your back tax returns, and then wait two years to file bankruptcy in order to have the taxes discharged.
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