Since each state has its own bankruptcy-related laws, most folks trying to find out if and how laws used in bankruptcy would work for them ask me about Indiana, and overlook federal law. As a long-time Indiana bankruptcy lawyer, I have good and bad news to share about the way federal income tax relates to bankruptcy.
To understand the “good news” part, you need to know that, under federal tax law, a debt cancellation is treated as taxable income. You might think, then, that if a bankruptcy court discharged debts worth, say, $10,000, the bankruptcy filer would need to report taxable income of $10,000. But, in most cases of bankruptcy, the IRS makes an exception for bankruptcy-discharged debts so that no tax is due. (You can read more about this in the Sapurstein and Associates newsletter)
What about the other way around, when the debt is owed to the IRS? The picture here is not nearly so rosy, I’m afraid. If you fall behind in your federal taxes (and don’t contact the IRS to work out a payment plan), the feds may decide to use their considerable power to collect from you. That could mean putting a lien on your property or even seizing some of your assets. In an earlier bankruptcy blog, Oh, Yes, You Can Get Rid Of Back Taxes!, I talked about one of the important kinds of help I provide to my Indiana bankruptcy clients, which is preparing Offers of Compromise to send to the IRS. Contrary to some myths, there are some taxes that can be discharged through bankruptcy. Generally speaking, if your tax debt is less than three years old, you’ll probably be advised to file Chapter 13 bankruptcy. (As I’ve often said, selecting a bankruptcy filing strategy, including which chapter to file, is one of the most important decisions I discuss with my Indiana bankruptcy clients.)
Years ago, a popular commercial ended with the line, “It’s Not Nice To Fool Mother Nature!” Not only isn’t it nice to fool the IRS, it’s not nice to make them wait for their money, either. Bankruptcy might offer relief from some tax debt, but make no mistake – taxes are at the top of the priority list when it comes to paying your debts.