Does Bankruptcy Clear Tax Debt?

Tax debts are treated differently than other kinds of debt when you file for bankruptcy. In most cases, taxes are not dischargeable in bankruptcy, but there are some exceptions such as fraud, mistakes or an undue hardship.

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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.

There are situations when filing bankruptcy can save you some money tax-wise, but in many cases you’re still on the hook.

“Most types of tax debt are not dischargeable in bankruptcy,” Oberon Copeland, CEO of Very Informed, said. “That means that even if you file for bankruptcy, you’ll still be responsible for paying any outstanding tax liability.

“However, there are some exceptions. If you can prove that your tax debt is the result of fraud or mistake, you may be able to have it discharged. Additionally, if you can show that paying your taxes would create an undue hardship, you may also be able to have your tax debt discharged.”

It’s important to note the difference between eligible debts for Chapter 7 vs. Chapter 13 bankruptcy

Income tax (with some restrictions) is the only kind of tax debt that can be discharged in a Chapter 7 bankruptcy filing.  In Chapter 13 bankruptcy,  you can’t generally discharge your tax debts but instead you can repay them through the life of your Chapter 13 repayment plan. That can last three to five years.

If you’re starting to think your best bet is to consult with tax and bankruptcy professionals for advice, good thought.

“You cannot eliminate tax debts by filing chapter 7 unless the tax is old enough – more than two years – you were honest when filing the returns, the taxing authority doesn’t have a lien on your property, and you meet the other rules specified by your court jurisdiction,” said Bill Ryze, certified chartered financial consultant and board advisor at Fiona.

“In most cases, you cannot discharge tax debts under Chapter 13 bankruptcy. In Chapter 13, the bankruptcy court offers you a way to repay your tax debts over the Chapter 13 payment plan.”

The takeaway: there could be some allowances made for tax debt in a bankruptcy filing. Just don’t count on it and you should seek counsel on whether any of those allowances fit your particular circumstances..

When Can Taxes be 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.

Tips and Financial Assistance to Pay Off Tax Debts

The IRS is more approachable than the stereotype of the unforgiving tax collector suggests when it comes to tax debt. But professional advice is recommended.

“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-term and long-term payment plans. If time is what you need most in order to pay back taxes, you might consider a mutually agreeable installment plan. Just know that interest rates and fees accrue during the payback period.
  • The IRS might be open to the option to settle your tax debt but you need to be up to date in filing your returns and show the financial wherewithal to make the monthly payments the IRS requires.
  • Offer in Compromise. This is a federal program that might allow you to settle your tax debt for less than you owe. It can be an especially helpful tool for low-income families.
  • If you can’t pay business taxes, a challenge that many small business owners launching start-ups face, you can ask the IRS for a 60-120 day extension to pay those taxes in full. Again, this is provided the IRS doesn’t already have a reason to consider you a tax scofflaw.
  • Seeking a full or partial abatement of penalties can greatly reduce the amount owed.
  • Pay in full as soon as possible. (I know, too obvious, right?). But minus an Offer in Compromise, this is the surest way to save interest and penalties.

“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.”

Getting Started With Bankruptcy

Rosenblum’s advice deserves repeating. Bankruptcy isn’t a fender bender easily resolved with an accident report and a call to the insurance agency.

It’s also nothing to rush into without first exhausting other avenues of debt relief, including debt management programs. A DMP is a strategic plan to eliminate unsecured debt such as credit cards and medical bills.

Understanding the pros and cons of specific debt relief strategies may help you solve debt issues without the short-term and long-term challenges of filing bankruptcy.

The reason bankruptcy is likened to a lifeline, after all, is that usually time is running out and the waters are getting choppier for those already swimming in so much debt they can’t see their way clear.

If that’s you – and a consultation with an experienced bankruptcy attorney confirms it – the next step is understanding the impact of bankruptcy.

Beyond the critical questions about the security of home, car and other assets in a bankruptcy, there’s the damage to your credit score.

A Chapter 7 bankruptcy filing impacts your credit report for 10 years. In Chapter 13, it’s seven years, but smart (and consistent) debt management can help you rebuild your credit while waiting for the bankruptcy filing to be cleared from your report.

Whether you hire an attorney or try to file bankruptcy on your own, there are filing fees involved. You’re basically paying the court for its trouble, and the cost of bankruptcy isn’t cheap. (Yes, I know, what is cheap these days?)

It’s easy – too easy and not real smart – for someone already in financial straits to assess court costs and decide they can’t afford attorney costs, too. Legal representation in a filing as complicated as bankruptcy is no place to cut corners.

In the wrong hands – yours, quite possibly – a bankruptcy filing is far more often a cement block tied to your ankle than it is a lifeline. So your next step should be to find a bankruptcy attorney.

Don’t  just randomly surf the web and pick a smart-sounding pitch from an attorney. It’s understandable if you’re shy about asking friends and family if they know someone, or someone who knows someone. Nobody wants their financial issues hanging from a clothesline for all their friends and relatives to see.

Limit your search to attorneys who specialize in bankruptcy. Check with the American Bar Association and look for websites that offer reliable ratings services for bankruptcy attorneys.

An experienced bankruptcy attorney will tell you (or should) that you need to go through credit counseling for bankruptcy before filing for Chapter 7 or Chapter 13. It’s designed to give you an accurate and clear picture whether your financial issues can be managed and resolved without filing for bankruptcy.

If they can’t and you file for bankruptcy, the IRS needs to be notified of the filing. If the IRS is listed as a creditor, U.S. Bankruptcy Courts will notify the IRS within a day or two of the petition date.

To be safe, you’ll want to call the Centralized Insolvency Operation and give them your bankruptcy case number.

Bankruptcy is a hard road to recovery but sometimes the only road available.

Whatever combination of bad luck and bad decisions steered you to the financial brink, bankruptcy can be a complicated and devastating decision that requires a full accounting of debt, assets  – and tax obligations – that isn’t easily managed without professional help.

About The Author

Robert Shaw

Robert Shaw writes about finding ways to solve financial problems like keeping up with mortgage payments, paying off credit card debt and avoiding bankruptcy for Debt.org. During his 45-year career in journalism, Robert was a columnist for the Cleveland Plain Dealer before transitioning to television sports commentary at WKYC.

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