Tax Debt and Bankruptcy

When taxpayers fall prey to tax problems, they typically can obtain tax relief from IRS tax debt (which includes back taxes and penalty and interest) in one of three IRS settlements. The first is an installment agreement which will mean that taxpayer will have to make the full payment of taxes including penalty and interest (unless there is a reason for penalty abatement).

The second alternative for a tax settlement is an offer in compromise whereby you offer to settle your IRS debt for less what is owed. The third tax help available to taxpayer is the currently not collectible. Taxpayer under this tax relief will enjoy the refrain of IRS from collecting the tax because taxpayers demonstrated to IRS that they don’t have the cash flow to pay their back taxes.

Bankruptcy may be another alternative available to taxpayers to seek IRS tax relief in one of two instances; the first instance is if the taxpayers fail to qualify or take advantage of the available three tax solutions cited above. The second feasible use of bankruptcy is when the taxpayers owe other debts and will file bankruptcy anyway.

Most of the time taxpayers can avoid bankruptcy by positioning themselves to benefit from an installment agreement, offer in compromise or the currently not collectible status without having to file for bankruptcy solely because of the tax issue.

Automatic Stay

Automatic Stay grants instant tax relief for the taxpayer against the collection actions by the IRS. The IRS will put a freeze code on your account. The IRS can no longer take any collection actions against you. Even IRS notices are considered to be actions in violation of the bankruptcy stay.

On the other hand, filing the bankruptcy will cost the taxpayer the benefit of running the statute of limitation on collection which is usually 10 years. The statute will be suspended as long as there is a stay in your favor. For example, if the stay is one year and you had 5 years left, then after one year you still have five years on the lapse of the statute (plus 30 days).

Taxes Covered in the Bankruptcy

All taxes prior to filing the bankruptcy are covered as long as they meet filings timing requirements. You must have filed all returns three years before filing bankruptcy. If the IRS filed a return for you in the past (SFR), that return may not get a bankruptcy protection. It is almost the same rules that you follow when you negotiate a tax settlement with IRS for your IRS debt.

Tax Assessment Dates and Filing of Bankruptcy

Notice also that the date of assessment of taxes must be more that must be more than 240 days from the time of the assessment. For example if as a result of the audit you have been assessed one hundred thousand dollars of tax on January 3, 2010, you must wait 240 days from that time (August 3) before you file your petition.

Tax Filing Requirement

If a taxpayer files for chapter 13 bankruptcy (which is for individuals), they will file a 1040 tax return at the end of the year as usual. If they are a business operating as a corporation or partnership, and thus filed chapter 11, they will also use the regular tax return whatever form 1120 for corporations (1120S for S-corporation) or form 1065 for partnership they usually file.

If an individual taxpayer files chapter 7 or 11 petition, they will be filing as an estate for the bankruptcy (estate tax returns are form 1041). Thus their 1041 will be used as a transmittal return for the form 1040. Since bankruptcy in this case is an estate, you must obtain a federal id number as you do in the corporation or the partnership.

Tax Consequences to Bankruptcy

Before considering bankruptcy you must consider the tax consequences of the bankruptcy. You must remember that you lose some of the tax benefits that you usually enjoy if you were not in bankruptcy. You will lose net operating loss deductions carried over and available otherwise for current years. Those losses can be very large and may outweigh the tax relief offered by bankruptcy.

To demonstrate the importance of the previous point, let us assume that a taxpayer is a corporation and had a $900,000 net operating loss. The corporation files bankruptcy because it has a tax problem. The tax debt is $25,000. The corporation thinks the only tax help (assuming they tried offer in compromise and were not successful) is to file bankruptcy to get rid of IRS tax debt of the $25,000. If this situation happened, we believe it would be unfortunate.

One of the solutions the corporation may consider is selling the company subject to the tax debt. Anyone in the 30% tax bracket will save $300,000 as a result of the tax savings from the net operating loss. So if they pay $100,000 to acquire the corporation and pay the IRS corporate debt of $25,000 they would have paid $125,000 for the corporation but saved $300,000 taxes. The taxpayer who owes the IRS got rid of their IRS debt plus $100,000 in their pocket. The point is one must not just jump into bankruptcy without considering all available solutions. Same thing can be said for capital loss, available tax credits and unused charitable contribution carried over from prior years.