Taxes and Bankruptcy
It’s a question tax attorneys get asked all the time: “Can my taxes be discharged during bankruptcy?” The answer, like the answer to most tax questions, is “it depends.” It depends on the type of tax, when the taxes were levied, whether the taxes were properly reported, and what type of bankruptcy process is being pursued.
In this guide, we’ll address what taxes are eligible for discharge through bankruptcy and how taxpayers can assess whether they qualify for a discharge. This is a general overview, and it’s important to consult with a trusted tax attorney before moving forward with bankruptcy.
Evident Pros can step into that role for individuals or business entities. Our expert team of attorneys, accountants and tax professionals have assisted hundreds of clients struggling with tax debt. For some clients, bankruptcy is the best option, and we regularly help overwhelmed taxpayers pass through the process with the best possible post-bankruptcy positioning.
Qualifying for a Tax Discharge During Chapter 7 Bankruptcy
Taxes are the most stubborn debts to discharge through bankruptcy. In fact, the only taxes that can be discharged are federal and state income taxes. Payroll taxes cannot be discharged, nor can any penalties, such as those levied due to fraud. That means those latter tax debts will persist through bankruptcy.
It’s important to note that not all income tax can be resolved through bankruptcy. Some important requirements must first be met, including:
- The debt is three years old (or older) – The tax return associated with the debt is used to date the debt’s age, so to speak. If the debt is at least three years old (using the date the tax return was originally due on), it satisfies this qualification.
- A tax return was filed for the debt in question – For a tax debt to be considered dischargeable, it must have been reported to the IRS using an accurate, on-time tax return.
- No fraud or willful evasion was committed – Any attempt to conceal or falsify income (or the taxpayer’s identity) will invalidate a discharge through bankruptcy. Misreporting income or using another person’s Social Security number are two examples.
- The debt was assessed at least 240 days in advance – In accordance with the “240 rule,” for a tax debt to be dischargeable, it must have been assessed by the IRS at least 240 days prior to filing for bankruptcy.
There are additional requirements for some jurisdictions, so the above may not be sufficient for your case. For example, some districts will not discharge tax debts if the tax return associated with the debt was filed late.
How are Taxes Handled During Chapter 13 Bankruptcy?
Unlike Chapter 7 bankruptcy, which seeks to discharge debts and clear the petitioner’s slate, Chapter 13 bankruptcy is formed around a repayment plan. Known as the “wage-earner’s” bankruptcy, Chapter 13 is only available to people who have a regular monthly income.
During the Chapter 13 process, debts categorized as dischargeable may be wiped out if the petitioner’s income is too low once necessary expenses are accounted for. Unsurprisingly, most tax debts cannot be discharged in this way, but there is an exception. Federal and state income taxes in arrears for longer than three years are considered dischargeable. As such, if the petitioner’s income is too low to pay them down once necessary expenses are subtracted, those taxes may be discharged.
Chapter 13 also offers a couple more tax advantages. One, taxpayers are not required to pay interest on dischargeable taxes – though non-dischargeable taxes will accrue interest. Two, if the IRS has placed a tax lien against the petitioner’s property, the lien can be satisfied and removed during Chapter 13 repayment.
How Are Tax Liens Affected by Bankruptcy?
As mentioned, tax liens may be resolved during Chapter 13, but they remain following a Chapter 7 discharge. The lien itself is not a debt. Instead, it is applied to assets (securities, a vehicle or home, for instance) in response to an unpaid tax debt. As long as the taxpayer has a lien against them, the IRS takes first priority among all other creditors should their assets be sold. As such, it can be difficult to transact assets when dealing with a lien.
Further, the IRS may move to seize the person’s assets if they do not commit to working with the IRS to pay the lien down.
If a lien has been levied against the taxpayer, bankruptcy will not be enough to remove it. The only way to resolve it is to pay down the debt associated with the lien, or to negotiate with the IRS to have it removed. This typically involves entering into a monthly repayment plan for any outstanding taxes.
Bankruptcy or Tax Returns - Which Should be Filed First?
There is no significant advantage to filing a tax return after filing for bankruptcy. In fact, petitioning for bankruptcy first can be a risk if your most recent tax return hasn’t been reported to the IRS.
During Chapter 7 and Chapter 13 proceedings, the taxpayer’s most recent tax returns will be reviewed – either by the bankruptcy trustee (Chapter 7) or prior to the 341 meeting with creditors (Chapter 13). If any of these recent returns are not available, the taxpayer will need to provide a compelling reason in writing, or their petition for bankruptcy may be dismissed.
If, for any reason, the most recent return cannot be provided, the IRS will estimate the taxpayer’s income for the missing tax year. As you might suspect, this estimation will not be in your favor, so it’s best to avoid leaving the calculation to the agency.
Considering Bankruptcy for Resolving Your Tax Debt?
Bankruptcy can solve tax debt problems for some people, but it’s not the only option taxpayers have. Offers-in-compromise and repayment plans are others, and for some, it may be possible to have penalties partially or fully abated. Business owners may also request extensions (up to 120 days, in most cases) if all they need is a bit more time to pay.
In short, taxpayers have several tools they can use to resolve outstanding taxes, including bankruptcy. If you’re struggling with your tax debts, determining your best course of action may be (almost) as difficult as paying the IRS. That’s where a trusted tax expert can help.
Evident Pros can assess the amount of your tax debt and provide a detailed review of all your options. Once a course is set, our team can gather all necessary documentation, move forward with bankruptcy (or an alternative form of tax resolution) and represent your case to the IRS and others involved in the process.
