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.

I Didn't File, but I Got Assessed Anyway -- Why?

From time to time even the best-intentioned tax payer can neglect to file an income tax return. When that happens, the IRS will often file a return on that tax payer's behalf -- it's called a Substitute for Return (SFR). And it's no favor.

Let's look at an example. Suppose Joe Smith failed to file his 2005 tax return. What happens? Typically, the IRS will file a return on Joe's behalf within 2.5 years (courtesy the Automated Substitute for Return System). The IRS calculates Joe's taxes by assessing his gross income for 2005, without regard to any specific deductions or exemptions for which he might qualify. The result is that Joe is assessed a tax much higher than he might have had if he prepared and filed the tax himself. Joe won't know about this until he receives a demand letter from the IRS.

The best solution, of course, is for a tax payer to prepare and file tax returns in a timely manner. But even where the IRS has filed a SFR, it's in the tax payer's best interest to file. By papering the SFR, a tax payer can take full advantage of the deductions and exemptions to which he is entitled, even if he's filing his return long after the return was actually due.

If you've received an assessment for a year you haven't filed, there's still time to make things right. Consult a tax professional and paper over the SFR.

Wesley Snipes, Actor, Millionaire, Cautionary Tale

There are people in this country (and you probably live with a few of them) who think everything in Hollywood is good and golden. These are the folks who can watch the descent of Britney Spears and Lindsay Lohan from cute pop stars to wrecked, plastic tabloid fodder and think -- Why not me?

For those people, there's nothing that can be done except making them comfortable and keeping them out of direct sunlight.

The rest of us, though, should take a good look at Hollywood and take a lesson from actor Wesley Snipes. Snipes, best known for the Blade vampire trilogy, was sentenced to three years in prison for willfully failing to file his income tax returns this past April. He was convicted in February on three misdemeanor counts of failing to file by a federal court in Florida. Snipes was acquitted of the more serious charges of felony conspiracy and tax fraud. (You can read more about the Snipes case here)

There's a lesson here, and here it is: It can happen to you.

Don't misunderstand. There are plenty of people in the country who have not filed income tax returns and who walk free today. Undoubtedly the IRS targeted Mr. Snipes and his cohorts (including his accountant and a tax protester organization to which Mr. Snipes belonged) because Snipes is a popular and bankable Hollywood star. Wealth and fame can make you a fat target. But the IRS does nothing without calculation, and the Snipes trial was meant to send a message. And the message has been heard: No one is immune from criminal prosecution if they don't file their tax returns.

Even before the Snipes case, the IRS was increasing efforts to enforce tax return compliance through penalties and other tactics. In recent years, the IRS has expanded the statute of limitations to pursue unfiled tax returns to six years from the date the return was due. The Service has also added a $25,000 penalty for each unfiled tax return (in addition to the threat of prison). The IRS has beefed up civil penalties as well. The Internal Revenue Code (the administrative laws governing the IRS's authority to collect taxes) lets the IRS impose a penalty of up to 25 percent of the amount owed for unfiled returns.

If you don't file, the IRS is likely to file on your behalf. This is no gift. While the IRS-created return (called a "Substitute for Return" or SFR) relieves you of your obligation to file, it does you no favors. The SFR only considers your income earned for a given year. It provides only one exemption and one deduction. In other words, an SFR does not take into consideration any of your actual expenses. It's a losing proposition for the tax payer.

The best defense against the criminal and civil penalties is to file your tax returns now. You might not have the paperwork, you might be afraid that filing will bring all the wrath of the IRS on you, or you might just hope the problem will go away. Put those issues aside and contact a tax professional who can help.

Take a lesson from Wesley Snipes.