Income taxes on debt discharged in bankruptcy

You’ll be pleased to know that in most cases there are no income taxes on debt discharged in bankruptcy.

However, outside of Chapter 7 bankruptcy and Chapter 13 bankruptcy, any discharge of indebtedness is taxed as income.

For example, if you settle a $10,000 debt for $5,000, then you can be taxed on the $5,000 that the creditor forgave.

Many creditors will send a 1099 form to the debtor and to the IRS so that the IRS knows to collect income taxes from the debtor.

Why?

The bankruptcy discharge is given this special treatment because Congress knows that people who file for bankruptcy do not have lots of money to pay taxes.

So it would be unfair to give them a big tax bill right after they file for bankruptcy.

In our experience, it is not uncommon to discharge $50,000 of debt in a Minnesota bankruptcy, but the income taxes on that could easily be $10,000.

No one who has just filed for bankruptcy could afford that tax bill, so people wouldn’t get the fresh start which bankruptcy relief is designed to provide.

Other types of debt forgiveness that can create big tax bills include:

Foreclosures
Short sales
Any settlement with a creditor for less than the full balance of the debt

Should you file for bankruptcy or settle IRS debts?

Since debts to the IRS are often not dischargeable in bankruptcy:

It is often better to file bankruptcy and be done with the debt than it is to settle the debts

This is because if you settle the debts, then you might be trading regular debts for IRS and state tax debts.

Why is the IRS more dangerous than other creditors?

The IRS is more dangerous than other creditors because the IRS can:

Place tax liens
Take future tax refunds to satisfy debts
Use traditional debt collection actions such as wage garnishment, and bank levy

Tax debts are also much more difficult to discharge in bankruptcy, often requiring that you wait 3 years or more before they can be discharged.

Because settling a debt often has the effect of trading a regular creditor for the IRS, it is wise to check with an experienced Minnesota bankruptcy attorney and maybe an accountant.

This will ensure that you know the best way to lower your debt without owing lots of money to the IRS before agreeing to a settlement with a creditor.

Please Note: This article does not constitute tax advice or legal advice.