Bankruptcy and Tax Liability

Chapter 7 Bankruptcy

Chapter 7 bankruptcy is a liquidation bankruptcy where you give up all your non-exempt assets in exchange for a discharge of all your debts.

Under a Chapter 7 bankruptcy, income taxes for years ending on or before the date of filing the bankruptcy petition (including extensions) and within three years of the filing date can't be discharged. But income taxes owed for periods longer than three years can be eliminated. And therein is where many people use the nation's tax laws to their advantage.

Meanwhile, payroll taxes -- Social Security and FICA -- or employee withholdings that you owed cannot be discharged, even after three years.

So if you work for a company in any capacity where you can be found to be a "responsible person," make sure that payroll taxes and withholdings are sent to the IRS. These are dollars that have been withheld from your employees and, if you are a "responsible person," the IRS can hold you personally liable for these business taxes.

If you're ever in a cash-flow position where you don't have the dollars to send what's due to the IRS, mark your check "trust fund portion only." The IRS can't hold you personally liable for the matching part of the Social Security and Medicare payments not sent in.

Chapter 13 Bankruptcy

Under Chapter 13 bankruptcy, designed for wage earners "with regular income," you agree to a plan to pay off your debts over a period of time, usually for pennies on the dollar.

Under chapter 13 bankruptcy, the court has the discretion to discharge taxes owed to the IRS without regard to the three-year rule, so long as you complete the payments under your Chapter 13 bankruptcy plan.

Even the IRS doesn't mess with the bankruptcy courts. When the bankruptcy courts say the tax is discharged or impose an automatic stay against collection, that's it. It's over. When the IRS didn't follow the rules, the United States Bankruptcy Court for the Southern District of Florida in a decision rendered in December 1999 found the agency to be in contempt of court and fined it $10 million.

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