Basic bankruptcy treatment of income tax for individuals.

• Author: Chambers, Valrie

The number of U.S. bankruptcy filings increased 9% from 2009 to 2010 (National Bankruptcy Research Center, 2010 Year-End Bankruptcy Filings Report (January 4, 2011)). With many more people filing for bankruptcy, clients often ask their CPAs, "Can I get rid of the income taxes I owe in bankruptcy?" The answer is "Maybe." This item attempts to clarify this answer and discusses certain aspects of bankruptcy and other options that CPAs need to be aware of in order to best represent their individual clients. (This piece is limited to income tax for individuals and does not cover other taxes such as employment or property tax or taxes for businesses, including corporations, that are discharged in a chapter 11 bankruptcy. For a discussion of corporate bankruptcy, see DeGeorgio and Chambers, "Tax and Pension Claims in Bankruptcy," 34 The Tax Adviser 481, 556 (August, September 2003)).

Discharge of Taxes

Taxes can be discharged in bankruptcy in either a chapter 7 or a chapter 13 filing. Under a chapter 7 bankruptcy filing, a taxpayer petitions the courts to discharge his or her debts in their entirety (liquidation). The debtor does get to keep some assets, known as exempt property. Normally, clothing, furniture, and personal items are considered exempt. Funds received from Social Security, unemployment compensation, veterans' benefits, and workers' compensation are also exempt.

Under a chapter 13 bankruptcy filing, the debtor develops a plan to repay all or part of his or her debts. The plan is submitted to the judge presiding over the case for approval. The debtor must have steady income in order to qualify for chapter 13. The debtor must make monthly payments to a court-appointed trustee, who then pays the creditors. The time period allowed for payment plans is a minimum period of three years and a maximum of five years (11 U.S.C. [section] 1322(d)). The moment a chapter 13 bankruptcy petition is filed, penalties and interest stop under the automatic stay rules (11 U.S.C. [section] 362). Sec. 6502(a) generally limits the IRS to a 10-year period to collect taxes after an assessment is made. The filing of a bankruptcy petition will toll (pause) the 10-year statute of limitation.

There are five rules taxpayers need to meet in order to discharge income taxes;

* The due date for filing the tax return, as extended, is more than three years before the filing of the bankruptcy petition (11 U.S.C. [section]507(a)(8)(A)(i));

* The tax return was filed more...