What Happens to My IRS Tax Debt if I File Bankruptcy?

Bankruptcy And Tax Debt

Within the realm of bankruptcy, taxes are generally classified as “nondischargeable priority debt.” It indicates that bankruptcy cannot eliminate tax debts, and the repayment of such obligations is prioritized over the claims of other creditors.

Nevertheless, there are situations where taxes can be categorized as “dischargeable debt,” meaning they can be eliminated by filing for bankruptcy.

When You Can Discharge Tax Debt

For tax debt to be considered dischargeable, it must meet specific criteria.

Firstly, it should pertain to income taxes, encompassing outstanding federal and state income tax obligations. However, it does not contain other back taxes, such as past-due payroll taxes related to Social Security and Medicare withholding.

Secondly, the tax debt must be of a different origin, typically within three years. The original tax return should have been due at least three years before the date of filing for bankruptcy.

For tax debt to be eligible for discharge in bankruptcy, it is necessary to have filed a valid tax return and for that tax return to have been assessed by the IRS at least Three (3) years before initiating the bankruptcy filing. Furthermore, the tax return must have been submitted within the prescribed deadline.

If an extension in filing taxes was requested and granted, filing the return by the extended due date is considered “on time.” However, suppose the return was filed after the extended deadline. In that case, it might be deemed invalid, resulting in the tax debt being ineligible for discharge since the assessment date will have been extended through the extension obtained.

Apart from the regulations concerning the debt age and the tax return timing, there is an additional prerequisite for tax debt to be considered eligible for discharge.

Specifically, the Internal Revenue Service (IRS) must have officially assessed the debt, meaning it has been recorded on the agency’s books at least three years before the initiation of the bankruptcy filing.

This requirement can also be fulfilled if the IRS still needs to assess the debt at the time of the bankruptcy filing.

One crucial factor to consider is ensuring that the taxing authority, typically the IRS, has not placed a tax lien on your assets. If a tax lien has been filed, a bankruptcy filing will not remove or lift the lien.

This scenario represents one of the most prevalent obstacles in seeking tax relief through bankruptcy, thus demanding special attention and careful consideration.

Bankruptcy cannot protect you if you have engaged in tax evasion or submitted a fraudulent tax return. The rules stipulate that tax returns must have been filed honestly to be considered for discharge in bankruptcy.

Moreover, various court jurisdictions may have additional criteria for eliminating tax debt through bankruptcy courts. While we have covered the primary conditions, you must familiarize yourself with local rules that may impose further requirements.

Federal Tax Liens and Bankruptcy

Distinctions exist between a tax debt and a tax lien. Tax debt refers to the money owed to the taxing authorities, while a tax lien is a legal encumbrance placed on your property to enforce the tax liability. This lien can encompass all your financial assets, including bank accounts, personal belongings, and real estate.

You Can’t Discharge Federal Tax Lien

Bankruptcy does not discharge a tax lien. Even if bankruptcy successfully discharges your tax debt, the IRS or other taxing authority will still maintain a legal claim to your property due to the existence of the tax lien.

Upon filing for bankruptcy, the IRS is prohibited from pursuing collection efforts on a tax debt that has been discharged. This holds even if a tax lien has been established.

As a result, the IRS cannot access your bank account or initiate wage garnishment to collect the discharged tax debt.

You can also continue residing in a home with a tax lien attached. However, it is essential to remember that when you eventually sell the house, the proceeds from the sale will need to be used to satisfy the outstanding tax lien. At that point, the tax lien must be paid off using the profits generated from the sale transaction.

Optimal Bankruptcy Options for Resolving Tax Debt

Tax debt has the potential to be discharged through various options provided by the federal bankruptcy code. Individuals can seek protection and relief by filing for bankruptcy under different chapters, including Chapter 7 and Chapter 13.

Chapter 12 is specifically designed for family farms and fishing operations, while Chapter 11 primarily addresses businesses and more significant debts.

These different bankruptcy chapters offer individuals and entities a range of options to address their tax debt and seek the necessary relief.

Addressing Tax Debt through Chapter 7 Bankruptcy

In a Chapter 7 bankruptcy filing, the debtor’s nonexempt assets will be subject to sale/liquidation by the Chapter 7 Trustee, with the proceeds distributed among the creditors. If limited or no assets are available to satisfy the creditors, eligible debts are discharged through Chapter 7, resulting in creditors receiving no payment.

According to the IRS, tax debts can be eliminated through Chapter 7 if they meet specific criteria, including being at least three years old and the taxpayer having filed returns for the past four tax periods.

Resolving Tax Debt with Chapter 13 Bankruptcy

According to the Internal Revenue Service (IRS), Chapter 13 bankruptcy is the predominant form of individual bankruptcy used to address tax debt.

Chapter 13, known as reorganization bankruptcy, involves creating a structured repayment plan with creditors to settle outstanding debts over three to five years gradually.

In contrast, Chapter 7 bankruptcy eliminates a significant portion of debts, rendering them no longer required to pay creditors or to be repaid.

Under a successful Chapter 13 filing, tax debts are paid off through the reorganization plan, and tax debts over three years old at the time of filing can be discharged.

The taxpayer must fulfill certain obligations during the repayment period, including filing tax returns promptly and promptly using tax refunds and paying any newly incurred income taxes.

In specific circumstances, a Chapter 13 filing may also result in the discharge of interest and penalties associated with the tax debt. Furthermore, interest on discharged tax debts will be erased, while penalties can be discharged if they exceed a three-year threshold.

When Should I Consider Filing for Bankruptcy: Before or After Taxes?

There is no significant advantage in delaying your income tax return until after filing for bankruptcy. However, for various reasons, it is essential to be up to date with your state income taxes, even when filing for Chapter 7 or Chapter 13 bankruptcy.

Chapter 7 Bankruptcy Filing and Tax Returns

When filing for Chapter 7 bankruptcy, the assigned trustee will request your last two years of most recent tax returns. It doesn’t have to be the return from the previous tax year, but if it isn’t, you’ll need to provide a written explanation.

The trustee will compare the income you reported on your tax return with the information in your bankruptcy paperwork. If you’re expecting a tax refund, the trustee will verify if you can protect or “exempt” it and if the claimed exemption amount is correct. Otherwise, you’ll be required to surrender the refund to the bankruptcy trustee, who will distribute it among your creditors.

Many individuals intend to use the tax refund for essential expenses before filing for bankruptcy. If you opt to file for bankruptcy using this strategy, it’s crucial to maintain records of your expenditures.

Chapter 13 Bankruptcy Filing and Tax Returns

Before filing a Chapter 13 case, it is crucial to have your tax returns up to date, although there is some flexibility within the rules. You must submit copies of the previous two to four years’ tax returns to the Chapter 13 trustee before the 341 meeting of creditors, a mandatory hearing for all filers.

If you are not required to file a return, the trustee may request a letter, affidavit, or certification explaining the reason. Sometimes, local courts may have additional document requirements specific to their districts.

Please file a return with the IRS, the state, or the city you reside in before your 341 meeting of creditors to avoid significant drawbacks for your bankruptcy case. Firstly, the trustee overseeing your bankruptcy will initiate a motion, allowing you a limited period to provide your tax returns. Please meet this deadline to avoid the court dismissing your case, depriving you of the opportunity to present your situation before a judge and seek a resolution.

Additionally, if you haven’t filed a return and owe the IRS, they might file a claim based on their own “best estimate” of your income. However, after filing an accurate and proper return, these estimates typically tend to be higher than you would own. Consequently, this can introduce complications and potential issues for your bankruptcy proceedings.

Income Tax Debt And Bankruptcy

Individuals often face various types of debts owed to the IRS, with unpaid income taxes being the most prevalent form.

The presence of looming unpaid tax debt can induce considerable stress, compounded by the fact that the IRS is known for its assertive efforts to collect such debts. As a prominent public entity, the IRS is the most significant debt collector worldwide, equipped with tools and capabilities that private debt collectors can only aspire to possess.

In Chapter 7 or 13 bankruptcy filings, income tax debt (subject to certain limitations) is the only type of tax debt that can be discharged. However, Chapter 13 offers the option to repay tax debts throughout previous bankruptcy filing through a structured repayment plan, typically spanning three to five years.

Does Bankruptcy Clear Tax Debts?

Achieving debt relief through bankruptcy requires careful consideration of timing and strategic planning, notably when eliminating tax debt. One crucial aspect of a successful bankruptcy filing is waiting until the tax debt has surpassed the three-year mark before seeking assistance from a bankruptcy court.

Gaining insights into your tax and debt repayment timeline is crucial, and to accomplish this, it is advisable to request transcripts of your tax account from the IRS. These transcripts will provide essential dates that will help determine whether it is appropriate to pursue bankruptcy to address your tax debt.

In cases where a tax lien complicates the process of eliminating tax debt through bankruptcy, it is essential to confirm the validity of the lien. Valid liens must accurately identify the taxpayer, specify the tax year for which the debt is owed, and include the correct assessed amount, among other pertinent details. Additionally, the taxing authority must have filed the lien in the appropriate office, which may vary depending on the state.

If a lien is found to be faulty or invalid, it will not impede the bankruptcy process. Reach out to a bankruptcy attorney for advice and understanding how to deal with liens.

If Chapter 7 bankruptcy is not a feasible strategy for eliminating tax debt, Chapter 13 may still provide a viable alternative. Under Chapter 13, debtors must make regular payments for three to five years, but it offers opportunities for discharging certain debts, including tax debt.

If bankruptcy turns out to be a bad option, then it is prudent to seek the advice of counsel that seeks a settlement directly with the IRS or the state taxing authority through an offer-in-compromise.  This option cannot be sought in bankruptcy. Still, it can provide a reasonable solution allowing you to reduce the overall tax liability while offering you a suitable payment plan and timeline to repay the settled balance.