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You may have heard that if you have a tax debt to the IRS up to your eyes, bankruptcy will not help you. It’s true, most of the time.
The nuanced reality is that filing for bankruptcy can eliminate tax debt, in some cases. So if you’re struggling with back taxes you can’t pay, here’s how to know if bankruptcy is an option to consider.
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Basics of Bankruptcy and Tax Debt
Filing for protection from your creditors under federal bankruptcy law will usually prevent debt collectors from harassing you and relieve you of many of your debts. However, tax debt is treated differently than other types.
In bankruptcy lingo, taxes are generally treated as a “non-dischargeable priority debt.” This means that bankruptcy will not eliminate them and the repayment of the debt takes priority over the claims of other creditors. Still, there are times when taxes can be considered a “dischargeable debt” that can be eliminated with a bankruptcy filing.
Tax debt clearance conditions
The first requirement for a dischargeable tax debt is that it be an income tax debt, specifically. This would include unpaid federal and state income taxes, but not, for example, retroactive payroll taxes such as withholding for Social Security and Medicare.
A second condition is that the tax debt must not be too recent, generally more recent than three years. To be more specific, the original tax return must have been due at least three years before the date of filing for bankruptcy.
Next, you must have filed a valid tax return for the debt at least two years prior to filing for bankruptcy. And the statement must have been submitted on time. If you requested and received extensions and filed before the extension date, this is considered “on time”. If you filed after the extension date, the return may not be considered valid and the tax liability will not be dischargeable.
In addition to the rules regarding the age of the debt and the time of return, the IRS must have assessed the debt – in other words, have it on the agency’s books – at least 240 days before the bankruptcy filing. This requirement can also be met if the IRS has not yet assessed the debt.
If the IRS assesses the debt and then stops collection due to a prior bankruptcy filing or other cause, the usual 240-day deadline could be extended, which could make it more difficult to repay the debt.
Note that if you have attempted to evade taxes or filed a fraudulent return, bankruptcy will not protect you. The rules say you must have filed your returns honestly. Also be aware that different legal jurisdictions may have other standards for eliminating tax debt through bankruptcy. We’ve gone through the main terms, but local rules may include other requirements.
Last but not least, it is essential that the tax authority, usually the IRS, has not filed a tax lien on your assets. If a lien has been placed, a bankruptcy filing will not lift it. It is one of the most common obstacles to obtaining tax relief through bankruptcy, so it deserves special attention and definition.
At a glance: conditions for paying the tax debt
To discharge the tax debt through bankruptcy, these conditions must be met:
- It must be an income tax debt
- It must be a debt of three years or more
- You must have filed a valid tax return for the debt two years before declaring bankruptcy
- The IRS must have registered the debt at least 240 days before you filed for bankruptcy (or not yet assessed it)
- You must have filed your returns truthfully – no tax evasion or fraudulent reporting
- The IRS must not have filed a tax lien on your assets
Can you discharge a federal tax lien?
While a tax debt is money owed to tax authorities, a tax lien is a legal claim against your property. The lien can be placed on all of your property, including bank accounts, personal property, and real estate.
Bankruptcy does not release a tax lien. This means that the IRS or other taxing authority will still have a claim on your property even if bankruptcy cancels your tax debt.
But once you’ve declared bankruptcy, the IRS can no longer attempt to collect a dischargeable tax debt, even if a lien is in place. This means that your bank account cannot be exploited or your wages cannot be seized to collect the tax debt. You can continue to live in a house with a tax lien. However, when you sell the home, the tax lien will need to be repaid out of the proceeds.
Best types of bankruptcy for tax debt
The tax debt can be discharged by filing for protection using one of the options available under the federal bankruptcy code. These include Chapters 7 and 13 for most individuals, Chapter 12 for family farms and fishing operations, and Chapter 11, which primarily concerns businesses and larger debts.
Chapter 13 is the most common type of individual bankruptcy filing for tax debt, according to the IRS. Chapter 13, known as a reorganization bankruptcy, involves making arrangements with creditors to pay off debts over a period of three to five years. In comparison, a Chapter 7 bankruptcy wipes out many debts, meaning they never have to be repaid.
In the event of a successful Chapter 13 filing, tax debts repaid under the plan of reorganization and all tax debts older than three years at the time of filing will be discharged. During the repayment period, the taxpayer must file timely returns and pay all new income taxes that come due.
Depending on the circumstances, interest and penalties may be discharged with a Chapter 13 filing. Interest on a discharge tax will also be discharged. The sentences are releasable if they date back more than three years.
In a Chapter 7 filing, the debtor sells most of the assets and gives the proceeds to the creditors. If there are insufficient or no assets to pay creditors, eligible debts are still canceled by Chapter 7 and creditors receive nothing. Tax debts can be erased by Chapter 7 if they are at least three years old and the taxpayer has filed returns for the last four tax periods, according to the IRS.
Bankruptcy Strategies for Tax Debt
Patience and timing are key to eliminating tax debt through bankruptcy. To begin with, a key part of a successful filing is to wait until the tax debt has passed the three-year mark before turning to bankruptcy court.
You also need to know what the IRS records say about the time. So, request transcripts of your tax account from the agency. The dates in these documents will help you know if it is too soon to declare bankruptcy to settle your tax debt.
If a tax lien complicates your efforts to eliminate the tax debt through bankruptcy, make sure the lien is valid. To be valid, lien documents must accurately name the taxpayer, the tax year for which the debt is owed, and the amount of debt that has been assessed, among other details. The taxing authority must also have filed the lien in the correct office, which varies by state.
A defective lien may be invalid and will not stand in the way of a bankruptcy.
If Chapter 7 doesn’t seem like a viable strategy for eliminating tax debt, Chapter 13 may still work. This approach requires you to make payments for three to five years, but offers the option of paying off some debts.
Tax Debt Alternatives to Bankruptcy
Bankruptcy is not the only option for dealing with tax debt. The IRS may be willing to put a plan in place for a delinquent taxpayer to repay their debt in installments. If tax debt is the main debt you’re dealing with, an IRS payment plan might be as good an option as Chapter 13 – and save you the legal fees.
If you cannot pay off your tax debt with an installment plan, you may be able to use the IRS’ “offer in compromise” program. Here’s how it works: You offer to pay the IRS less than the full amount, and if you qualify, the IRS will forgive the remaining balance. But understand that you cannot make an offer in compromise once you have declared bankruptcy.
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While it is true that most taxes cannot be eliminated by bankruptcy, some can. Income taxes that were owed more than three years ago can be paid by filing in Chapter 7 or Chapter 13.
A bankruptcy filing won’t lift any liens that tax collectors have placed on your assets, but it will stop other efforts to collect the debt by garnishing your wages or dipping into your bank accounts.