Top 3 Questions Regarding IRS Taxes and Bankruptcy

Top 3 Questions Regarding IRS Taxes and Bankruptcy

In addition to common debts such as mortgages, credit cards, personal loans, medical bills, and real estate taxes, our office frequently assists individuals and married couples with IRS debt in Pennsylvania and New Jersey. Below are the three most common questions we field relating to IRS debt:

1. After I File for Bankruptcy, Can I Keep My IRS Tax Refund?

After filing for Bankruptcy, you can keep your IRS refund whether filing a Chapter 7 or Chapter 13 Bankruptcy matter.  A tax refund is a sum of money generally due in the future.  The sum of money can also be approximated based on income, family size, and previous years’ IRS refund amounts.  Such a sum of money can be “exempt” or protected in a Chapter 7 Bankruptcy matter. 

In Chapter 13 matter the refund can be amortized throughout the year and offset with expenses.  For example, if a bankruptcy filer(s) is in expectation of receiving a tax refund in the amount of $6,000.00, we would amortize such refund over 12 months, or add $500.00 per month to the bankruptcy petitioner’s income.  Then, we would offset the $500.00 monthly income with expenses of $500.00.  Most people we see have their tax refunds allocated toward regular expenses such as car insurance, repairs, tuition, utilities, etc.  Accordingly, it is generally very simple to offset the tax return with expenses and protect the tax refund in a Chapter 13 matter.  

2. Am I Taxed on Debt Forgiven in Bankruptcy?

No, debt forgiven by way of Chapter 7 or Chapter 13 Bankruptcy is not taxed as income.  IRS topic 431 clarifies that debt canceled “through in a Title 11 Bankruptcy case” is not taxable.  Chapter 7 and Chapter 13 are both part of Title 11 of the United States code.  

The treatment of debt canceled through bankruptcy differs from debt forgiven through a debt settlement plan outside of bankruptcy, such as debt consolidation.  Many of our clients find their way to us after a failed debt consolidation plan.  Even if a portion of debt can be satisfied through debt consolidation, the unpaid portion of the debt is subject to taxation as income to the borrower in the form of a 1099 tax form. Further, the amount forgiven by the lender is tax deductible.  For example, if one has a debt in the sum of $10,000.00 and they are able to settle the debt outside of bankruptcy for a lump sum payment of $6,000.00, the forgiven portion or $4,000.00 will be taxed as income.  Meaning if the Borrower makes $60,000.00 in annual salary per year, they must add the $4,000.00 to their taxable income for the year the debt was satisfied and must pay taxes on $64,000.00 ($60,000.00 plus $4,000.00) of gross income, which will increase their taxes due.  

The absence of taxation on forgiven debt through 1099 is one of the most advantageous and overlooked benefits of a bankruptcy filing.  The lack of income tax on a forgiven debt is a factor that must be considered by a debt relief professional when deciding on the best legal strategy for you.  

3. Are IRS Taxes Dischargeable in Bankruptcy?

Unfortunately, the answer depends, but in many cases taxes can be discharged in Bankruptcy, or the taxes can be repaid in whole or in part through a more financially manageable Chapter 13 Bankruptcy Plan.  Below are the requirements for tax debt to be forgiven or “discharged” through a Bankruptcy proceeding:

  1. The tax debt must have become due, even after any filed extensions, more than three (3) years prior to the filing of the subject Bankruptcy Petition;
  2. The tax return must be filed more than two (2) years prior to the filing of the subject bankruptcy matter;
  3. The taxes must be assessed by the IRS more than 240 days before the filing of the subject bankruptcy matter.

It is most important prior to a Chapter 13 Bankruptcy filing to analyze tax transcripts for the tax years in question.  Tax transcripts can be obtained online by individuals by visiting the IRS website.

If you have any further questions regarding your particular IRS debt, please contact the debt relief attorneys of Sadek and Cooper at 215-545-0008 in Pennsylvania or at 856-890-9003 in New Jersey.  We look forward to helping you.

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Amer Mustafa

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