Eliminating Tax Debts in Bankruptcy

One reason for filing for bankruptcy is to eliminate secured debt, such as mortgages, car loans, and tax liens. But it's hard to include this type of debt. Secured creditors often challenge a debtor's bankruptcy petition, as does the federal government.

Unfortunately, most debtors are still liable for tax debt after bankruptcy. The bankruptcy courts are strict about discharging tax liabilities. But, the Bankruptcy Code does allow for the discharge of tax debt in some circumstances.

Here, we'll explain what happens to your tax obligations when you file a Chapter 7 or Chapter 13 bankruptcy case. We will also explain which types of tax debt are more likely to be dischargeable. Contact a skilled bankruptcy attorney if you still have questions about your bankruptcy case.

Taxes and Bankruptcy: The General Rule

The courts are more likely to discharge tax debt in a Chapter 7 bankruptcy than in a Chapter 13 bankruptcy. In Chapter 13, the bankruptcy laws require you to include your tax debt and other secured debt in your repayment plan.

Chapter 7 bankruptcy allows a debtor to discharge certain debts, such as credit card debt, medical bills, and, in some cases, federal tax debt.

Can I File Bankruptcy on Tax Debt?

Taxpayers may be able to file bankruptcy on some types of tax debt. For instance, you can discharge income tax debt if you meet certain conditions. The same may be true for back taxes.

You must pass the means test to qualify for a Chapter 7 bankruptcy case. The means test compares your income to the state median income. If your income is too high, the court may allow you to amend your bankruptcy petition to a Chapter 13.

If you do this, a payment plan will be developed that allows you to pay back some or all your debt. Your payment plan will last three to five years. Once you complete your payment plan, the courts may allow for a bankruptcy discharge.

Bankruptcy and Taxes: Qualifying for Discharge

Whether the courts will discharge tax debt in your bankruptcy case depends on several factors. These include:

• The type of tax
• How old the tax debt is
• Whether you filed a tax return
• The type of bankruptcy

Federal income taxes in Chapter 7 are dischargeable if you meet all the following conditions:

• The discharge is for income taxes: Payroll taxes and penalties for fraud are not eligible for discharge.
• You filed legitimate tax returns: You filed a tax return for the relevant tax years at least two years before filing for bankruptcy.
• The tax liability is at least three years old: The tax debt is from a tax return you filed at least three years before filing for bankruptcy.
• You did not commit tax evasion: Possible evasive actions include changing your Social Security number, your name, or the spelling of your name. It also includes filing a fraudulent return, repeated failure to pay tax, or lying on your income tax return.
• You did not commit tax fraud: The return contains no information intended to defraud the IRS. For example, you cannot lie about owning real estate or having cash in hidden bank accounts.
• You are eligible under the 240-day rule: The IRS assesses the tax debt at least 240 days before you file for bankruptcy. The court may extend the applicable date if the IRS suspends collection activity during bankruptcy proceedings.

We'll discuss the 240-day rule in more detail below.

Tax Debt, Bankruptcy, and the 240-Day Rule

You must meet three requirements for the U.S. Bankruptcy Court to discharge your tax debt. Essentially, this rule requires that the IRS assess any taxes you include in your petition at least 240 days before your bankruptcy filing.

There are two other rules you must follow if you wish to include tax debt in your Chapter 7 bankruptcy or Chapter 13 reorganization:

• Two-year rule: You can only include tax debt from tax returns you filed more than two years before your bankruptcy petition.
• Three-year rule: You can only include more than three years old debt.

If you try to include a tax liability that doesn't meet all three requirements, the court will exclude it from your petition. These rules can become confusing. It may be best to have your tax or bankruptcy lawyer review your petition before you file it.

Tax Debt Not Eligible for Discharge

The following types of tax debt are not dischargeable in Chapter 7 bankruptcy:

• Tax penalties from tax debt that is ineligible to get discharged
• Tax debts from unfiled tax returns
• Trust fund taxes or withholding taxes withheld from an employee's paycheck by the employer

You can consider other arrangements if you can't discharge tax debt under Chapter 7. For example, you can enter into an installment agreement with the IRS or make the IRS an offer in compromise, which will settle the tax debt for less than the total amount.

Does Bankruptcy Clear Tax Debt?

You can clear or discharge tax debt if you fulfill the conditions listed above and the debt is for income tax.

Penalties on taxes that are dischargeable are also eligible for discharge. After the discharge of tax liability, you will no longer be responsible for paying the taxes, and the IRS may not garnish your wages or execute levies on your bank accounts.

But, the courts will not discharge federal tax liens from before your bankruptcy case. You would have to pay these liens to gain clear title to your property.

Get More Answers from a Bankruptcy Lawyer

The interplay of taxes and bankruptcy is complicated. If you have old tax debt adding to your debt nightmare, consider speaking with a local bankruptcy lawyer about your options.