Can You Discharge Tax Debt in Bankruptcy?

You can include your tax debt in a bankruptcy petition. That’s the good news. Most of it is not dischargeable in bankruptcy. That’s the bad news. Only some types of tax debts are dischargeable in bankruptcies under certain conditions.

The Bankruptcy Code permits debtors to claim IRS debts based on their age and the nature of the tax. The chance of discharge depends on whether you’re filing Chapter 7 or a Chapter 13 bankruptcy case. This article reviews which types of tax debt are more likely to be dischargeable. You should discuss your plans with a skilled bankruptcy attorney if you still have questions about your bankruptcy case.

Types of Bankruptcy and Tax Debt

The courts are more likely to discharge tax debt in a Chapter 7 bankruptcy than in a Chapter 13 bankruptcy. In a Chapter 7, debtors liquidate their assets to pay off secured and unsecured creditors, but lack sufficient income to make monthly payments. In a Chapter 13, debtors have some ability to continue making payments to creditors.

Automatic Stay

In all bankruptcy actions, filing a petition initiates an automatic stay on some collection actions. The stay applies to IRS tax debt collection (such as tax liens on your property), but it does not stop tax audits, tax deficiency notices, or tax return demands.

Chapter 7 Bankruptcy

A Chapter 7 bankruptcy, also called a liquidation bankruptcy, lets you discharge secured and unsecured debts. Credit card debts, medical bills, and personal loans are examples of dischargeable debt. Some debts cannot be discharged, such as student loans and most federal tax debt. You can discharge some income tax debt under certain conditions:

• The discharge is for income taxes only, not payroll taxes or penalties for fraud
• You filed tax returns for the previous two tax years before filing bankruptcy
• Your tax liability is at least three years old
• You did not commit tax fraud or tax evasion, such as filing fraudulent returns, failing to pay taxes for more than one year, or lying about concealed bank accounts
• You meet the 240-day rule, which states the IRS must have assessed the tax debt at least 240 days (eight months) before you file for bankruptcy (a court may extend the date if the bankruptcy petition suspended the IRS activity)

If you qualify, you can discharge:

• Federal taxes
• State taxes
• Penalties for dischargeable taxes

Each bankruptcy is different and unique.

Even if you meet the requirements for a Chapter 7 discharge, some types of tax debt will not qualify. These include:

• Nondischargeable tax debt like payroll taxes or trust fund taxes
• Tax penalties from nondischargeable taxes
• Tax debts from unfiled tax returns
• Tax fraud penalties
• Tax liens
• Recent tax debt (within the deadlines)

The IRS can resume collection on all taxes not discharged by your bankruptcy. You can request an installment agreement or make an offer in compromise. You may want an attorney’s advice to help you with these alternatives.

Chapter 13 Bankruptcy

A Chapter 13 bankruptcy, also known as a reorganization, allows a debtor to keep most of their property, and create a repayment plan to pay off most of their creditors over a three to five year period. In a Chapter 13, tax debt is part of a repayment plan with other secured debts.

As with a Chapter 7, your tax debts must meet the same time deadlines. You must pay off all priority tax debt with your repayment plan. “Priority” taxes are those that do not fall within the 240/2/3 timeline. Non-priority taxes are dischargeable at the end of the repayment period.

The IRS may garnish your tax refunds during the repayment plan period to cover part of the repayment plan. On the plus side, the bankruptcy suspends wage garnishment during the same time period. Penalties and interest do not accrue on past taxes during your payment plan.

A Chapter 13 bankruptcy is preferable if your tax obligations include an extensive amount of older, non-priority taxes that are dischargeable at the end of the repayment plan. You may also prefer a Chapter 13 if you intend to keep your assets during the bankruptcy and you have less concern over clearing your tax debt.

Important Times to Remember

There are three important rules to keep in mind when you’re considering putting your tax debt in your bankruptcy filing.

• The three-year rule means that the tax debt must be three or more years old for discharge
• The two-year rule means you may only include tax debt from tax returns filed more than two years before your bankruptcy petition
• The 240-day rule means the IRS must assess any taxes included in the petition at least 240 days before your bankruptcy filing

What does this really mean in practice? Here’s an example with real numbers:

The tax year is 2019. Your taxes were due (with extensions) on or before July 15, 2020. You filed your returns on April 1, 2020. The IRS assessed the returns on January 1, 2021. You filed bankruptcy August 1, 2024.

Your tax debt is four years old (the three-year rule), you filed three years ago (the two-year rule), and the IRS assessed the taxes three years ago (more than 240 days ago). These taxes can be included in your bankruptcy.

If your tax liability doesn’t meet all three requirements, the court will exclude it from your petition. For instance, suppose you filed for tax year 2019 in 2023 and filed bankruptcy in 2024. Although the debt meets the three-year rule, the filing would not meet the two-year rule. As a result, the court would probably exclude that debt.

Tax Liens

Bankruptcy can discharge your personal liability for tax debt. Federal tax liens on your property are not discharged. You must pay off the tax lien, or else request a removal of the lien through other legal action.

• Your attorney can request a discharge of a specific lien. The IRS has different code provisions for exempting certain properties.
• A withdrawal of public notice helps ensure there are no other creditors on the property, making it easier for you to pay off the tax. There are several methods for doing this. Consider consulting an attorney before trying this method.

Courts will not discharge federal tax liens from before your bankruptcy case.

State vs. Federal Tax Debt

Similar rules apply to state income taxes and state tax liens. State income taxes are dischargeable in a bankruptcy discharge, but tax liens aren’t. Bankruptcy laws differ by state regarding property taxes and other taxes.

It’s important to note that if the IRS or state filed a tax return on your behalf, you cannot claim those taxes on your bankruptcy.

What Happens After Discharge?

If your discharge is successful, the IRS will stop collection efforts on the discharged taxes. Any taxes not cleared by the bankruptcy remain active, and you must pay them. All tax liens remain, and you must either pay them or arrange for their removal through legal means.

You must continue to file all future tax returns and make any tax payments and installment payments you arranged during your bankruptcy.

A Chapter 7 is a chance at a fresh start, but you still need to keep up with your debts and payments. Your attorney can explain in more detail what happens after your bankruptcy discharge.

When You May Want or Need a Lawyer

Taxpayers may not always need an attorney when they file bankruptcy, even when it involves their taxes. If your filing meets the 3/2/240 rule, you can put your tax debts in your bankruptcy filing and see what the judge says. You may want an attorney’s advice if any of these situations apply to you:

• Late filing: If you filed your returns late, it changes the timing of the 3/2/240 rule. It may also impact whether the state or IRS filed a substitute return for you. Before filing, have your attorney check whether your tax filing falls into the rule, and whether the IRS filed on your behalf.
• Offers in Compromise: An OIC is an offer to pay a lump sum that is less than you owe in total. The IRS is often willing to accept OICs, but you should have your attorney review your offer before sending it in.
• Pay by installment: If you do not qualify or your debt is not discharged, the IRS may accept an installment agreement. The IRS website allows you to select payment plans that let you pay monthly and lets you arrange bank transfers.
• Can’t meet payments: Currently not collectible status requires that you prove your current income does not meet your monthly living expenses and also pay your tax debt. The CNC status is not permanent, and penalties and interest continue accruing while collection action is stayed.

Taxes are complicated enough. Adding bankruptcy on top of that is a legal labyrinth. If you have old tax debt adding to your financial nightmare, it’s a good idea to speak with a local bankruptcy lawyer. States have specific laws about bankruptcy exemptions, so your attorney must know local rules before heading to bankruptcy court.