Do I Have To Pay Taxes On Discharged Debt In A Chapter 7 Bankruptcy?

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If you are like many Americans, you have faced some amount of debt in your life. At times, this debt can be so overwhelming that you may have to consider filing for something like Chapter 7 bankruptcy. Chapter 7 bankruptcy is a liquidation bankruptcy that wipes out most of the general unsecured debts of the bankrupt that includes medical bills, credit cards, etc., without the requirement of paying back balances by means of a repayment plan.

Chapter 7 bankruptcy is basically for those individuals who have a limited or low income, and they are not able to pay back all or a portion of their debts. It’s important to note that, while we are talking about general Chapter 7 bankruptcy, there are some variations that occur from state to state. This means that a Chapter 7 bankruptcy in Wisconsin may look a little different from an Alabama Chapter 7 bankruptcy. Keep this in mind when determining whether or not Chapter 7 bankruptcy in your state is right for you.

For someone who has gone through Chapter 7 bankruptcy, it would sound pleasant that there are no income taxes on a debt discharged in most of the cases of Chapter 7 bankruptcy. On the other hand, it must be noted that any discharge of indebtedness outside Chapter 7 bankruptcy is taxed as income. Let say that Chapter 7 bankruptcy settles a $20,000 debt for $10,000, he/she can be taxed on the $10,000 that is forgiven by the creditor. Form 1099 is sent by most of the creditors to the debtor in addition to the IRS so that the IRS becomes aware of the collection of income taxes from the debtor.

This special protocol is given to the discharged debt in a Chapter 7 bankruptcy because the Congress fully understands that the individuals who have to file for bankruptcy are out or short of money and therefore, they would not have a lot or extra amount of money to pay as taxes to the government. The bankruptcy relief is designed to offer a fresh start to the bankrupts that cannot be availed if Chapter 7 bankrupts are imposed with a tax bill that they cannot after just filing for bankruptcy. So, to overrule the prejudice, Chapter 7 bankrupts are not given a big tax bill right after when they are filing for their bankruptcy.

Although, the Internal Revenue Service (IRS) considers debts discharged or canceled debts to be the income that is required to be reported on the tax return. It is not a comprehensive statement as it is not applied to ALL debts discharged in Chapter 7 bankruptcy. The reason is that canceled debts, forgiven debts, or debts discharged are the ones where the creditor is either prohibited from chasing you for money or agrees to stop pursuing you for money.

Debts discharged or canceled debts are no longer owed by the Chapter 7 bankruptcy individual, therefore these are not considered as ‘income’ usually in a chain of a bankruptcy proceeding. However, this rule may not apply if the individual has debts forgiven outside of bankruptcy. On the other hand, there are many cases where the individual is not required to report these as income also.

You do not have to pay taxes on discharged debt in a Chapter 7 bankruptcy if the taxes are income taxes, no fraud or willful evasion is committed by the bankrupt, debt is at least 03 years old, the bankrupt passes “240 days rule of assessment” and bankrupt has filed the tax return. The conditions in which you have to pay taxes in Chapter 7 bankruptcy include recent property taxes, tax liens, third-party taxes, employment taxes, erroneous tax refunds as well as non-punitive tax penalties.

Requirement & Conditions to Discharge Income Tax Debt in Chapter 7 Bankruptcy

Clear the misunderstanding that you cannot get rid of tax debts in Chapter 7 bankruptcy. You can discharge (wipe out) income tax debts in a Chapter 7 bankruptcy, and this is true. You SHOULD NOT need to pay taxes on discharged debt in a Chapter 7 bankruptcy if you meet the following requirements to get rid of your tax debts in Chapter 7 bankruptcy:

1.      Your Taxes Should Be Income-Based

Your income taxes are the only type of debt that is able to be discharged in case of Chapter 7 bankruptcy. It is necessary that your tax debt ought to be for state or federal income taxes or taxes on gross receipts.

2.      Your Return Should Be Due Minimum 3 Years Ago

You may not need to pay taxes on that tax return that was due at least three years before the bankruptcy is filed. All valid extensions are also included in the due. Suppose in a 2010 income tax return, your taxes were disclosed to which extensions for filing the return expired on October 15, 2011. Now, in this case, the tax return due date will be valid if the bankruptcy petition is filed subsequent to October 15, 2014.

3.      Your Return Should Be Filed Minimum 2 Years Ago

You may not need to pay taxes on discharged debt in a Chapter 7 bankruptcy if your tax return was filed at least two years before filing the bankruptcy. In the majority of courts, a late return is not considered as a “return”, therefore, the taxes are not eligible to be discharged. While there are other courts where tax debt can be discharged (wipe out) even if a tax return is filed late, assuming the supplementary standards are met. You may want to check with your bankruptcy attorney if you filed Chapter 13 bankruptcy.

4.      Your Taxes Should Be Assessed Minimum 240 Days Ago

At least 240 days prior to the Chapter 7 bankruptcy is filed, it may be necessary that the taxing authority has assessed the taxes and the liabilities against the bankrupt. If an Offer-in-Compromise (OIC) exists between the taxing authority and bankrupt individual, the time limit of 240 days may be extended. Another case that allows an extension in the time limit of 240 days is the previous filing of bankruptcy.

5.      Your Tax Return Should Be Scam-Free

No fraud, scam, or determined evasion should be found in your tax return. Along with it, Chapter 7 bankruptcy individual should not be accused of any type of intentional act of evasion of the tax laws. Not only this, if the individual files a joint tax return, but both of the spouses also should not be found committing any act of fraud in the tax return as well as willful attempt in evading the tax & to save tax by getting bookkeeping services.

Taxes on discharged debt in a Chapter 7 bankruptcy is a complicated and diverse topic and we have just presented a short overview to it. It must be noted that the rules are different in case of different debtors, creditors, and taxpayers. Therefore, it is best to consult an experienced professional of Chapter 7 bankruptcy so that you can get the best legal advice before making any final decision regarding your finances and assets.

Note: This article is not legal advice, nor should it be understood as such. This information is for informational purposes only, and you should not make a decision solely based on this information. Feel free to reach out to a tax advisor if you have questions.