Over 400,000 Americans file bankruptcy cases every year with the hope that it will finally wipe out their debt. However, when it comes to federal taxes and other tax obligations, the rules are not always in your favor. Some tax debts qualify for bankruptcy discharge. Others stick around, not minding the type of bankruptcy you file. So, bankruptcy can clear debt, but only under specific conditions.
Bankruptcy was never designed as a means of tax escape. The Internal Revenue Service (IRS) has rules concerning the kind of taxes that can be discharged, how old your debt must be, and whether your tax returns were filed on time. The type of bankruptcy you file also matters, as some allow for complete discharge, while others require a structured repayment plan.
When it comes to dealing with tax debt and bankruptcy, you need straight answers and real results. Victory Tax Lawyers make it simple. We have the best tax attorneys who can help you cut through uncertainties, assess your unique case, and guide you through the bankruptcy filing process. Schedule a free consultation now to get the best possible outcome.
In this guide, we’ll walk you through how bankruptcy affects your tax liability, the kind of debts that can be discharged, and what to do if your tax situation doesn’t qualify.
What Is Considered Tax Debt?
Tax debt is any unpaid amount you legally owe to the federal or state government. It can include property taxes, back taxes from previous years, penalties for underpayment, interest added to past due taxes, or taxes newly assessed after an audit. In simple terms, if the IRS states you owe a certain amount in debts and you are yet to pay, that amount becomes a significant tax debt.
Does Bankruptcy Clear Tax Debt?
Yes, bankruptcy can discharge tax debt. However, it is highly dependent on the tax you owe, how old the debt is, and whether you’ve met specific legal requirements.
Bankruptcy was set up to in order to give honest taxpayers a fresh start. However, the system draws a line between dischargeable debts and debt the agency still expects you to pay. For instance, prepetition taxes, which are older income tax debts, may be wiped out if they meet what’s known as the 3-2-240 Rule. On the other hand, payroll taxes, fraud penalties, and debts associated with recent income taxes cannot be cleared through bankruptcy filing.
Types of Bankruptcy and Their Impact on Tax Debt
When it comes to dealing with tax debt through bankruptcy, the right approach will largely depend on your financial circumstances. Among the different types available, Chapter 7 and Chapter 13 are the most commonly used by individuals looking to manage or erase tax debt.
Chapter 7 offers a way to discharge certain tax debts entirely, provided specific criteria are met. On the other hand, Chapter 13 allows you to repay your tax debt over time through a court-approved payment plan. Here’s a closer look at how each option works and what it could mean for your tax situation:
Chapter 7 Bankruptcy (Liquidation)
Chapter 7 bankruptcy is commonly known as straight bankruptcy. When you file for bankruptcy under this chapter, the court will appoint a trustee to take stock of your non-exempt assets, liquidate the assets, and utilize the proceeds in paying creditors.
Always keep in mind that tax debt only gets cleared under Chapter 7 if it meets the following strict requirements known as the 3-2-240 Rule:
- The 3-year rule implies that the tax return must be due at least 3 years before your bankruptcy was filed.
- For the 2-year rule, you must have filed your tax return at least 2 years before the bankruptcy.
- As for the 240-day rule, the IRS must have assessed the tax debt at least 240 days before you filed.
Also, any form of tax lien will survive the bankruptcy if the IRS had already filed one prior to now. The eligible tax debt may be cleared, but the lien still gives the IRS a legal claim to your property even though you filed for bankruptcy.
Chapter 13 Bankruptcy (Repayment Plan)
Chapter 13 is often referred to as the reorganization bankruptcy. Instead of eliminating your tax debt, it enables you to restructure your debts into a manageable, court-approved repayment plan, typically spread over three to five years. Under this arrangement, you make regular payments based on what you can afford, rather than the full amount owed.
A Chapter 13 bankruptcy is very helpful because it gives you the ability to:
- Include back taxes in your payment plan.
- Stop additional interest and penalties from accumulating.
- Halt IRS collection actions like tax liens and levies, which could be seizure of your bank account, retirement income, social security benefits and wage garnishments.
- Protect your home or other important assets.
Unlike Chapter 7, Chapter 13 involves flexibility. On this note, your repayment plan can often be modified if your financial situation changes. Additionally, you’ll be fully protected from IRS collection action while catching up at a pace you can manage well without stress.
To qualify for Chapter 13 bankruptcy, you must have a steady income and meet specific debt limits outlined by the bankruptcy code. The limits apply to secured and unsecured debts and are updated by the IRS periodically.
Additional Types of Bankruptcy
Aside from Chapters 7 and 13, there are other chapters that serve more specialized groups depending on your business structure or residency.
Chapter 11 serves mostly businesses by allowing them to remain operational while restructuring debts under court supervision. Under this type of bankruptcy, tax liabilities can be included in a reorganization plan, and the terms may extend beyond the 3-5 year time frame for Chapter 13. However, the exact timeline is dependent on what was approved by the court.
In contrast, Chapter 12 is primarily for family farmers and fishermen. It combines features of Chapters 13 and 11 by allowing a repayment plan while accounting for both seasonal and irregular income. Tax debt can be included in the plan, and bankruptcy courts have the flexibility to reduce tax balances or modify terms.
Then there’s Chapter 15, which is the type of bankruptcy that governs cross-border insolvency. It is utilized mostly in international cases, when a debtor or company has assets, operations, or tax obligations in different countries.
Lastly, Chapter 9 bankruptcy code involve municipalities. While this chapter doesn’t apply to individual taxpayers, it gives public entities such as cities, counties, and school districts, full permission to restructure debt in order to avoid service disruption and insolvency.
How Long Does Bankruptcy Last?
The length of a bankruptcy case depends entirely on the chapter you file under. Chapter 7 bankruptcy can last for 3 to 6 months. Chapter 13, however, lasts 3 to 5 years, depending on the repayment plan. Other types of bankruptcy, like Chapters 11, 12, 15 and 9, can last even longer depending on the negotiations that have been done with creditors and the case complexity.
How to Resolve Tax Liabilities and Get Your Tax Debts Paid
To resolve your tax debt through bankruptcy, you must first understand your eligibility, meet the timing requirements and choose the right legal strategy. As stated earlier, bankruptcy can discharge some tax debts, but not all. So, to make it work for you, it’s best to follow these steps carefully:
1. Evaluate your Tax Debt
Start by reviewing your full tax history. Request an IRS transcript to see what’s on file, like the years you owe, how much is due, and whether the IRS has assessed your tax return or filed substitute returns on your behalf. This step alone also clears up confusion if you have certain debts that may have been created through fraud or evasion.
2. Understand the 3-2-240 Rule.
Next, determine what portion of your tax debt may be eligible for discharge if you consider filing for bankruptcy. This is precisely where you need to understand the 3-2-240. As mentioned earlier, this Rule means your tax periods must have been due at least 3 years ago, filed at least 2 years ago, and your tax must have been assessed at least 240 days before your bankruptcy filing.
3. Choose the Bankruptcy Chapter That Fits
Once you know the portion of your tax debt eligible for relief through bankruptcy, determine the type of bankruptcy that can offer you the best outcome. Chapter 7 may be ideal if your income is low, you don’t have significant assets, and your tax debts qualify under the 3-2-240 Rule. This option is faster but may involve the liquidation of non-exempt property.
On the other hand, Chapter 13 allows you to pay back what you owe using a repayment plan. You can go for this option if your tax debt doesn’t qualify for discharge or if you’re trying to save your home and avoid asset liquidation.
4. Consult a Tax Professional
It’s okay if you’re unsure whether bankruptcy is the right option for you. However, make sure you consult a bankruptcy attorney before you even get to filing. They can help you compare your options, estimate what’s dischargeable, and avoid mistakes that could delay relief or cost you more in the long run.
5. Complete the Filing Process Properly
When filing for bankruptcy, include all necessary documents, such as tax returns and proof of income. You must also attend credit counseling and complete all required paperwork from the court. If you filed under Chapter 13, you’ll begin making monthly payments under a court-approved plan. If you filed Chapter 7, you’ll have to then wait for your discharge notice, which typically arrives within a few months.
6. Follow Through After Bankruptcy
Discharging or paying down tax debt through bankruptcy is a huge milestone, but still not the end. Moving forward, stay compliant with your taxes to avoid falling back into the same pattern. You’ll have to file your returns on time, make estimated payments if you’re self-employed, and adjust your withholding if necessary.
What Happens to My IRS Tax Debt if I File Bankruptcy?
Your tax debt can either be reduced, restructured, or even erased completely if you file bankruptcy, but only when you qualify. The tax debt you owe and the time you filed your returns will significantly influence how that debt is treated. If your tax debt adheres to the 3-2-240 Rule, it may be completely wiped off under Chapter 7.
Should there be a case where your tax debt doesn’t qualify for discharge, it still doesn’t make you out of options. Tax debts are included in your 3 to 5 year repayment plan when it comes to a Chapter 13 case. The benefit here is that while making your payments, the IRS will stop every collection action like wage garnishment or bank account seizure. The automatic stay also protects you. Likewise, penalties and interest usually stop accruing.
However, if your tax debt involves tax penalties associated to fraud, or recent tax returns, these debts are generally non-dischargeable. No type of bankruptcy can be able to clear them, and you’ll still have to get them paid.
How Unpaid Taxes Accumulate
Unpaid taxes accumulate through missed payments, underreported income and overlooked tax filings. When you don’t pay what you owe within the stipulated time, the IRS immediately begins adding late fees, which starts with a failure-to-pay penalty of 0.5% per month, plus daily interest in most cases. Errors on your return, underreporting income, or missing a filing altogether can also lead to reassessments that may increase whatever you may have owed in tax debt.
How Can You Clear Income Tax Debt?
You can pay income tax debt through bankruptcy, but only if specific rules are met. The most common path is Chapter 7 or Chapter 13 bankruptcy. For the debt to be wiped out, it must meet the 3-2-240 Rule.
However, timing isn’t the only factor. You must also have filed the tax returns yourself because substitute returns filed by the IRS don’t count. If your return also involves fraud or willful tax evasion, the debt will not be eligible for discharge. Chapter 7 may wipe out your debt entirely once your taxes are eligible, while Chapter 13 will roll them into a repayment plan.
What to Do When Tax Debt Cannot Be Cleared in Bankruptcy
Utilize a different strategy if your tax debt doesn’t qualify for clearance through bankruptcy. As stated before, payroll taxes, trust fund penalties, or recent income taxes are non-dischargeable. So, the best approach to get them cleared and avoid personal liability using different IRS relief programs or negotiating an IRS resolution.
Explore an IRS Payment Plan
If your tax debt can not be discharged through bankruptcy, you can request a payment plan from the IRS. An installment agreement enables you to pay the amount over time in monthly installments without any further collection action. This option won’t reduce the tax debt you owe. However, it will make repayment more manageable.
Look Into an Offer in Compromise
An Offer in Compromise (OIC) is an IRS relief option that gives you the freedom to settle your debt for less than whatever you owe, as long as you can prove that you’re financial handicapped. To qualify for this alternative option, submit a detailed financial record while the IRS evaluates your income, expenses, assets, and ability to pay.
Consider Currently Not Collectible (CNC) Status
In a situation where you genuinely can’t afford to pay anything toward your tax debt, you may be eligible for Currently Not Collectible status. With this option, the IRS can temporarily halt collection activity, such as tax liens, levies or wage garnishment, based on your financial hardship. Also, be fully aware that interest and penalties may continue to accrue when you opt for this alternative. However, it will buy you more time until your financial situation improves.
Request Penalty Abatement
Requesting a penalty abatement can be very much helpful if you have accrued a lot of penalties on your tax debt. To qualify for a penalty abatement, you must demonstrate reasonable cause like illness, natural disaster, or another serious circumstance that delayed you from paying on time. The IRS may also decide to grant you a First Time Penalty Abatement if you’ve had a history of compliance.
Work With a Bankruptcy Attorney
When tax debt can’t be cleared through bankruptcy, alternative solutions can also be tiring. A bankruptcy attorney can evaluate your situation, recommend the most strategic options, and represent you in negotiations with the IRS.
How Bankruptcy Affects Different Types of Tax Debts
Not all tax debts are treated the same way when it comes to filing bankruptcy. The type of tax you owe directly impacts whether your debt can be discharged or not.
Income Tax Debts vs. Other Tax Types
Income tax debt can be discharged in bankruptcy if it meets the laid down criteria, such as the debt’s age and filing timing. However, other types of taxes, such as payroll, sales, and trust fund recovery penalties, are termed priority debts and are not eligible for discharge under any bankruptcy code.
Federal vs. State Tax Debt
Federal tax debt is generally more straightforward to discharge because it follows well-defined rules under the bankruptcy law. In contrast, state income tax debt is dependent on individual state laws, which may vary in how they treat eligibility and discharge. Some states are stricter with timing, penalties, and how they apply the 3-2-240 Rule.
California’s Treatment of Tax Responsibilities in Bankruptcy
California mirrors federal bankruptcy guidelines when it comes to tax dischargeability. However, the California Franchise Tax Board (FTB) may be more firm in its collection efforts and stricter in reviewing discharge eligibility. While older income taxes may be discharged, recent taxes, penalties, and debts tied to fraudulent tax return will typically remain collectible under California law.
Should You File for Bankruptcy to Clear Tax Debt?
Bankruptcy can provide relief from tax debt. However, the decision must be taken carefully. While eliminating or restructuring IRS tax liabilities is possible, you must be aware of inevitable trade-offs.
Pros and Cons of Filing for Bankruptcy
On the positive side, bankruptcy can fully discharge eligible income tax debt if it meets the age and filing requirements of the 3-2-240 Rule. If you qualify, that means no more monthly payments, no IRS collections, and no accumulating penalties. Chapter 13 is also a good alternative for taxpayers who don’t qualify for Chapter 7 bankruptcy because it allows repayment of tax debt over time without interest and under the court’s protection. In both cases, bankruptcy stops IRS collections actions. However, there are downsides you must weigh.
Bankruptcy will negatively affect your credit score because Chapter 7 stays on your report for over 10 years and Chapter 13 for up to 7 years. Secondly, not all tax debts are dischargeable either. Recent returns, payroll taxes, and fraud-related liabilities will still follow you. Another disadvantage to keep in mind is regarding tax refunds. Filing bankruptcy can delay or reduce your expected tax refund. The tax refund could be seized and used to repay creditors, mostly if it’s considered part of the bankruptcy estate.
Do the Pros Outweigh the Cons?
The answer depends solely on your situation. If you have old and well documented tax debt, your debts meet all discharge rules, and you don’t mind the credit impact, then filing for bankruptcy may be worth it. On the other hand, if you have assets you’re trying to protect or are dealing with non-dischargeable tax types, you can opt for an installment agreement, Offer in Compromise, or any other alternative.
Need a Tax Lawyer to Help You Resolve Your Tax Debt Issues?
Filing for bankruptcy can help you clear tax debts. However, not all tax debts will be cleared. Also, even if this could be the right option for you, there are strict rules and timing requirements that you must meet such as qualifying for a Chapter 7 discharge or Chapter 13 repayment plan. On top of that, dealing with the IRS on your own can be taxing, mostly when the stakes involve your wages, your home, or even your credit.
At Victory Tax Lawyers, we help taxpayers handle complicated debt, avoid missteps, and make informed decisions that hold up long-term. So, whether bankruptcy is the right path for you or not, our bankruptcy attorneys can help you understand your options clearly so you can act with full confidence. Schedule a free consultation and let’s talk through your next step. You can also talk to us in person by visiting our office in Los Angeles, California.
FAQ
Can I File for Bankruptcy Without Losing My Home?
Yes, in many cases, you can file for bankruptcy without losing your home. Chapter 13 bankruptcy allows you to keep your home while catching up on payments. Additionally, chapter 7 bankruptcy may also protect your home if your equity falls within exemption limits.
Will All My Debts Be Cleared in Bankruptcy?
No, your debts won’t be completely cleared if you file a bankruptcy. Some debts like student loans, recent tax debts, child support, and fraud-related obligations are generally not dischargeable.
What Happens When Marriage and Tax Debt Are Involved?
You’re not liable for your spouse’s tax debt. However, if you file jointly with your spouse, both of you may be liable for the full amount. On a second note, filing separately can protect one spouse from post petition tax liabilities but often comes with fewer tax benefits. Conversely, if your spouse had pre-marriage tax debt, the IRS may still garnish joint tax refunds unless you request injured spouse relief.
What Happens to My Retirement Accounts in Bankruptcy?
In bankruptcy, qualified retirement accounts like 401(k)s and IRAs are protected up to a certain limit. These accounts are generally exempt from liquidation. This means that creditors cannot have access to them, allowing you to preserve your long-term financial security even while resolving current debts.
Does Bankruptcy Clear a Tax Lien?
No, it doesn’t. A federal tax lien that was previously recorded may still attach to your property until paid or released even if your tax debts have been discharged through bankruptcy filing.
How Do I Get My IRS Debt Forgiven?
To get your IRS tax debt forgiven, you may qualify for an Offer in Compromise or Currently Not Collectible status. Each option has strict eligibility requirements.
