Tax Debt and Bankruptcy: Five Things to Keep In Mind

Studies suggest that up to 50 percent of U.S. bankruptcies are related to medical emergencies. Tax debt problems are also a major contributor to financial distress that can eventually lead to bankruptcy. However, unlike unpaid medical bills, IRS tax debt is not automatically erased by a successful bankruptcy filing.

In fact, if you're not careful, bankruptcy can make your need for tax debt help even more acute. Here are five things to keep in mind if you are contemplating bankruptcy and how it may help or hurt your chances at tax debt relief:

1. Don't Rely on Bankruptcy as Your Only Option. The bankruptcy legislation signed into law by President Bush in 2005 has made the more forgiving version of bankruptcy, Chapter 7, a less unforgiving process. Don't assume that you will qualify under the new rules, which include strict income and means tests.

Consider debt settlement plans before even entering the bankruptcy process. Speak with a money management counselor to see what your other options are.

2. File All Tax Returns Before Filing Bankruptcy. This is less a recommendation than a requirement. The Internal Revenue Service, in fact, has the power to actually halt a bankruptcy proceeding if not all tax returns are filed for the last four years. Bankruptcy judges can be ordered to dismiss your case if you do not cooperate with income tax law.

3. Bankruptcy Cases May Create a Potentially Taxable "Estate." Dealing with tax debt-related bankruptcy can be extremely tricky.

For example, let's say that you are filing Chapter 13 bankruptcy. The time will come where your assets--car, house, bank accounts, rental property, whatever else--will be legally sequestered off into its own entity, referred to by the IRS as an "estate." This estate may produce taxable income. For instance, if your bank account gains interest.

A good tax debt attorney may be needed if you are filing bankruptcy with income-producing assets.

4. Look Out for Those 1099-C Forms. One of the worst things about bankruptcy is a tax form called "1099-C." These forms represent "cancelled debt," which in turn represents taxable income to you.

Make sure to speak with your bankruptcy and/or tax debt attorney about this matter. Often, if the issue is addressed ahead of time, these 1099-C forms can be avoided, or you can have the tax on them included as part of your overall bankruptcy proceeding.

Surely it's a tragedy if you shed $50,000 in credit card debt only to be saddled with a $10,000 income tax bill.

5. Pay Income Taxes While You're In Bankruptcy Court. Just because you're broke doesn't mean you don't owe taxes on the income you are receiving. That may be a harsh truth but it's the truth. Make sure to pay appropriate taxes while you are going through bankruptcy.

Whether it's through your W-2 at work or quarterly estimated taxes if you're self-employed, taxes remain a part of life, bankruptcy or not.

About the Author:
Andrew Freiburghouse is a freelance writer and editor living in Brooklyn, NY. He has worked in a variety of fields including magazine journalism, tax preparation, screenwriting, copywriting, and real estate. He graduated from Santa Clara University in 1999 with a B.A. in English. A regular contributor at tech blog Edgelings.com, Andrew was born and raised in the City of Los Angeles. He hopes he will survive the New York winter.