Bankruptcy Isn't What It's Cracked Up to Be

Is it worth declaring bankruptcy to avoid a burdensome tax debt? For better or worse, the answer is: Probably not. In almost all cases, tax debt survives a Chapter 7 or Chapter 13 bankruptcy.

First a word about taxes and bankruptcy in general: Some tax debt can never be discharged through bankruptcy. Tax debt arising from unfiled tax returns cannot be discharged. So, for example, if you fail to file your 2005 return, and the IRS files a substitute for return on your behalf, any assessed taxes from 2005 cannot be discharged. The only way to avoid this situation is to file your return (even if you are filing over the SFR).

So is there any tax debt that can be discharged by bankruptcy? The general answer is yes. Chapter 7 provides for full discharge of allowable debt, and Chapter 13 provides a payment plan to repay some debts with the rest being discharged. That being said, tax debt will not be discharged unless the tax payer can demonstrate that they have met certain requirements. The requirements are these:

• The tax debt must be related to a tax return that was due at least three years before the tax payer files bankruptcy
• The tax debt must be related to a tax return that was filed at least two years before the tax payer files for bankruptcy
• The IRS must assess the tax at least 240 days before the tax payer files for bankruptcy
• The tax return cannot be returned for fraud
• The tax pay cannot be guilty of any intentional act of evading the tax laws

What are the effects of filing bankruptcy? Be warned -- it's been my experience that most people who file bankruptcy either cannot meet the requirements listed above (and so do not have their tax debts discharged) or just fail to complete the bankruptcy process . Instead of having their debts discharged, their bankruptcy is merely dismissed, and the tax payer is back to Square One.

It's true that filing for bankruptcy puts an automatic stay on IRS collection efforts against you. During bankruptcy, the IRS is prohibited from imposing a lien or levy. That's the good news. The bad news is that bankruptcy extends the Collections statute of limitations. That means if some of your tax debt survives bankruptcy, the IRS now has additional time to collect it.

If you're considering bankruptcy as a means to avoid tax debt, consult a professional before you do anything.