BEWARE THE TAX MAN — EVEN AFTER BANKRUPTCY

Bankruptcy may shield you from creditors, but the IRS still can go after you for at least some unpaid taxes. Here’s a guide to your tax liability after you file for bankruptcy.

Bankruptcy originally meant “broken bench.” In common-law England, when a merchant or craftsman couldn’t pay his debts, the custom in the community was to break his workbench. This publicly established that the craftsman was “no longer in business.” Quite often, the creditors at that time would seek to perform the ceremony across the head of the debtor.

Now, bankruptcy laws are used as proactive shields not only to deflect creditors, but also to eliminate them in some cases.

Of course, you also have a very nasty black mark against your credit history. Most bankruptcy filings remain on your credit reports for seven to ten years. For the first several years, you can forget about credit cards (unless they’re secured credit cards, in which the credit limit is backed by cash in an account with the lender), car loans and mortgages.

And then there’s the Internal Revenue Service. You wiped out all of your other creditors (while in most cases getting to keep your home, which typically is exempt from bankruptcy proceedings), but you still have a huge tax bill hanging over you. Under what circumstances will the government let you off the hook?

The rules are complex and sometimes courts in different jurisdictions interpret them differently. Let’s see if I can simplify them.

All debts are divided into two categories — dischargeable and non-dischargeable. If the debt is dischargeable, you no longer are liable for it. Non-dischargeable debts can’t be canceled in a bankruptcy.

How the rules are applied depends on the kind of bankruptcy you elect — either Chapter 7 or Chapter 13. These are the two most common types of bankruptcy filings available to individuals.

Chapter 7

This 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 older 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 if they are older than three years.

So, for example, 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 employer matching part of the Social Security and Medicare payments not sent in.

Chapter 13

Under this form of 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 this kind of 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 plan.

Even the IRS doesn’t mess with the bankruptcy courts. When the courts say the tax is discharged or impose an automatic or permanent 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. IRS also had to make full restitution and amends to the taxpayer in question. The appeals court declined to listen to IRS’s pleadings. The decision stands. IRS paid the fine.