Does Bankruptcy Clear Tax Debt?

You’ve probably heard bankruptcy likened to a financial lifeline.

Harassing phone calls from creditors stop. Having waves of debt washed away – not without consequences, mind you – can nevertheless feel like a lifesaver.

But even in the best of outcomes, there will likely be an undercurrent tugging at you:  tax debt.

Taxes are treated differently than other kinds of debt when you file for bankruptcy. Unless you thought the IRS might see what a nice, well-intentioned person you really are and forgive back taxes, hearing that tax debt doesn’t get discharged in a bankruptcy filing probably doesn’t surprise you.

Bankruptcy & Taxes: What to Know

Filing for bankruptcy may offer some tax relief, but in most cases, you will still be responsible for paying what you owe. Most tax debt is not dischargeable, meaning it typically survives the bankruptcy process.

“Most types of tax debt are not dischargeable in bankruptcy,” said Oberon Copeland, CEO of Very Informed. In limited situations, older income tax debt may qualify for discharge under Chapter 7, but only if you meet strict requirements. These usually include filing your tax returns on time, avoiding fraud or errors, and ensuring there are no tax liens on your property.

The type of bankruptcy you file matters. It’s important to note the difference between eligible debts for Chapter 7 vs. Chapter 13 bankruptcy. Chapter 7 may allow certain qualifying income tax debts to be eliminated, while Chapter 13 generally does not discharge tax debt at all. Instead, Chapter 13 lets you repay what you owe through a structured plan over three to five years.

The bottom line is that bankruptcy is not a reliable way to erase tax debt. Because the rules are complex and exceptions are limited, it’s smart to consult a tax or bankruptcy professional to determine what applies to your situation.

When Are Taxes Discharged In Bankruptcy?

There’s no one-size-fits-all answer to when taxes can be discharged in bankruptcy. (I know, surprise, surprise.) The answer depends in part on the different types of bankruptcy filed.

The two clearest rules about dischargeable debt in bankruptcy: it must be income taxes; and it can’t be “fresh” income tax debt.

“The debt must be from income tax that was filed at least three years before filing for bankruptcy,” said Anthony Martin, founder and CEO of Choice Mutual. “The IRS must also have been aware of this debt. If a fraudulent return was filed or there was a previous attempt to hide the debt, then it will not be cleared from the bankruptcy.”

While you might well still be dealing with tax debt after a Chapter 7 bankruptcy filing, tax debt in a Chapter 13 filing typically will be settled in full over the 3-5 year repayment period.

Managing Tax Debt With Chapter 7 Bankruptcy

Chapter 7 bankruptcy can be the quicker, less complicated (but still painful) way to clear debt. But it’s predicated first on you qualifying to file Chapter 7. Your tax debt can be discharged under Chapter 7 if:

• It’s income tax.
• The debt is at least three years old.
• You did nothing fraudulent to evade paying your taxes.
• You filed a tax return for the debt you hope to discharge at least two years before filing for bankruptcy. A late filing beyond the allowed extensions could disqualify your debt as dischargeable.
• You must pass the 240-day rule, meaning the IRS must have assessed the tax debt at least 240 days before your filing.

Managing Tax Debt with Chapter 13 Bankruptcy

Chapter 13 bankruptcy, also known as “Wage Earner’s” bankruptcy, is a reorganization of debt that must be repaid over a 3-5 year period. Not as quickly resolved as Chapter 7, it can be the smarter option in dealing with tax debt under the following conditions:

• Tax debt older than three years might be forgiven, depending on your amount of disposable income (minus necessary expenses).
• Discharged tax debt won’t incur additional interest or penalties.
• IRS tax liens can be satisfied in a Chapter 13 repayment plan.
• The IRS must abide by your Chapter 13 repayment plan, provided all income is included in the plan and you meet all current tax obligations.

Federal Tax Liens and Bankruptcy

A federal tax lien is a government sanction. It’s a legal claim against your property when you fail to pay a tax debt, protecting the government’s interest in personal property, real estate and financial assets.

“The federal tax lien can be discharged from the person, but not from the property,” said Jasmine DiLucci, Principal at DiLucci CPA Firm and JD Tax Law. “Due to bankruptcy, the IRS won’t be able to pursue you for any additional amount above and beyond the value of the property.”

Even under circumstances where your tax debts qualify for being discharged in a Chapter 7 filing, that won’t change the status of a prior recorded tax lien. It doesn’t go away.

You can continue to live in a house with a lien on it, but you can’t sell that property without first paying off the lien.

“Tax liens are not typically wiped away with filing bankruptcy,” Martin said.

“A lawyer may be able to get a lien removed if there was an error in the filing of it or if the lien is at least 10 years old.”

But again, don’t count on it.

Should You File Bankruptcy Before or After Filing Taxes?

There may be instances particular to your situation where an experienced bankruptcy attorney would say the timing might benefit you one way or the other. But the shortest answer is that typically there’s no great advantage to waiting to file your income taxes until after you file bankruptcy.

As a rule, there are reasons why it’s more important to keep your tax filings up to date when you’re considering filing Chapter 7 or Chapter 13 bankruptcy.

The Role of Tax Returns in Chapter 7 Bankruptcy

Chapter 7 bankruptcy requires you to provide your current income tax return and any returns filed during the bankruptcy proceedings.

The trustee assigned to your Chapter 7 filing will use your most recent return to compare the reported income to the amount listed on your bankruptcy filing.

He or she will also want to assess any expected tax refund to make sure that money can be legally exempted from going to your creditors to pay off debt.

The Role of Tax Returns in Chapter 13 Bankruptcy

Tax returns from the previous four years are required in Chapter 13 bankruptcy.  That’s a precursor to the 341 meeting of creditors required of all filers.

So, again, being up to date is important, maybe critically important if you owe the IRS a return but have failed to file it before meeting with creditors.

If you’re wondering what’s the worst that can happen, your case can be dismissed if you miss the deadline to file your returns after the trustee files a motion on your behalf to give you time.

Your only other option might be the IRS supplying a substitute “estimate of income” return that often errs on the high side of determining income tax owed. It’s best not to leave that up to the IRS.

How to Pay Off Tax Debt

The IRS is more approachable than the stereotype of the unforgiving tax collector suggests. In other words, there are a few tax debt relief options. Whichever route you choose, it’s recommended that you start by hiring a tax attorney.

“The best option is usually to work with a tax attorney since there are different programs or options with the IRS to resolve your situation,” said  DiLucci. “I always warn against using national firms mostly with unlicensed workers or tax professionals with minimal experience in tax debt since the industry is not highly regulated.

“Too often we see individuals paying large fees and are left in the same situation with unresolved tax debt and IRS tax liens and levies.”

So, there are some options to get help with tax debt, but, as you probably expected, there are strings attached to that help.

• Short- or long-term payment plans: If you need time to pay back taxes, you can set up an installment agreement with the IRS. Keep in mind that interest and penalties will continue to accrue during the repayment period.
• IRS settlement eligibility: The IRS may consider settling your tax debt, but you must be current on filing your returns and able to demonstrate the financial ability to make agreed-upon payments.
• Offer in Compromise: An offer in compromise is a federal program that may allow you to settle your tax debt for less than you owe, particularly if you have limited income or financial hardship.
• Business tax extension: If you can’t pay business taxes, you may qualify for a 60 to 120 day extension to pay in full, as long as the IRS does not already view you as noncompliant.
• Penalty abatement: Requesting a full or partial reduction of penalties can significantly lower your total tax bill.
• Pay in full: Paying your balance as soon as possible is the most effective way to minimize interest and penalties, especially if you do not qualify for an Offer in Compromise.

“Tax debt can be overwhelming since the longer you take to pay, the more the interest and penalties accrue,” said Ryze.

His short list of options, with comments:

• Personal loan: “Predictable monthly payments, eliminates the risk of the IRS issuing a tax lien on your property, and avoids IRS penalties.” The downside: “Will increase your debt, which could affect your credit rate. Additionally, you might spend more if you don’t qualify for a good interest rate,” he said.
• Credit card: Could help avoid interest on the tax debt. Allows you to spread out your payments. Downside: “Opening a new credit card can hurt your credit score and lead to deeper debt.”
• Home equity loan: “Gives you flexible repayment duration and eliminates the risk of the IRS placing a lien on your house. Most home equity has a lower interest rate than personal loans.” Downside: “You’ll decrease your home equity, risk losing your home and increase your mortgage obligations.”

How Will Bankruptcy Affect Future Tax Filings and Refunds?

It’s not enough to know how bankruptcy affects your credit rating, or for how long. It’s also important to know how bankruptcy affects your taxes, especially in regard to future filings and refunds.

Most people understand that a tax refund due in a year when they file Chapter 7 bankruptcy, as opposed to future filings, will become an asset of the “bankruptcy estate” and might be earmarked by a trustee to pay off creditors.

In Chapter 13, tax refunds can be kept by the trustee in every year of the prepayment plan. That can happen only once in Chapter 7.

A proper use of exemptions and intelligent timing of the bankruptcy filing petition can preserve some of your tax refund in a Chapter 7 filing. It’s best to seek professional advice on tax refunds after bankruptcy.

“If you decide to go the bankruptcy route, make sure you get an experienced bankruptcy lawyer,” said Dai Rosenblum, an attorney and Counselor of Law based in Butler, Pa. “Bankruptcy is a complicated and highly technical area of law.

“General practitioners should not dabble in bankruptcy. Every consumer bankruptcy lawyer I know of offers a free, first consultation, so there is nothing to lose. You should learn your options before making a final decision.”

The Bottom Line

Bankruptcy can be a lifeline, but it’s not for everyone. It may make sense if you’re overwhelmed with debt, out of options, and unable to keep up with payments even after exploring alternatives like debt management plans. If your debt is still manageable or tied mostly to obligations like tax debt that typically can’t be discharged, bankruptcy may not provide the relief you’re looking for.

Tax debt plays a limited role in bankruptcy. While some older income tax debt may qualify for discharge under strict conditions, most tax obligations remain and must still be paid. That makes it important to understand exactly what relief bankruptcy can and cannot offer before moving forward.

If bankruptcy seems like your best option, your next step should be to consult a qualified bankruptcy attorney. They can review your full financial picture, explain your options, and guide you through required credit counseling for bankruptcy and the filing process. Bankruptcy is a serious decision, but with the right guidance, it can be a path toward financial recovery.