Taxes have a way of sneaking up on us. And sometimes, we end up in a situation where we owe the IRS a lot of money in taxes. Thankfully, if you’re in over your head in debt, a chapter 7 bankruptcy will clear tax debt if the taxes meet certain requirements.
Which Tax Debts Qualify for Discharge?
Can you file bankruptcy on taxes? Yes. If you’re looking to discharge your tax debt, the best option is Chapter 7. Also called “straight” bankruptcy, Chapter 7 may offer full discharge for eligible debts. Keep in mind that not all back taxes can be eliminated. You need to meet the following conditions:
- Tax must be income taxes. Does bankruptcy clear state tax debt? Yes. Income taxes, both federal and state, can be eliminated in Chapter 7 bankruptcy.
- Tax debt is 3 years old. The tax debt must be from a tax return that has a due date of at least three years old before you file for bankruptcy.
- The tax return must be filed accurately. All the information included in your tax return should be accurate. Filing for bankruptcy may not be able to help if you filed a tax return fraudulently or if you attempted to evade paying taxes.
- The tax return was filed at least two years before the bankruptcy. The back taxes you want to discharge must be related to a tax return that you filed at least 2 years ago before filing for bankruptcy. If you filed a late return, it can’t be eliminated through bankruptcy.
- The IRS must have assessed debt 240 days before the bankruptcy. You need to meet the 240-day rule, which means the IRS must have assessed your income tax debt at least 240 days before you file for bankruptcy. Your tax debt won’t be discharged if it fails to meet these criteria. You still owe taxes to the IRS and must pay them.
Why Do You Need to Get an Automatic stay?
When you file a Chapter 7 or Chapter 13 bankruptcy, the court will issue an automatic stay that will prevent the IRS from collecting your back taxes. This means your creditors, including the IRS, cannot call, bill, garnish or sue you. All collection efforts will be stopped.
The automatic stay won’t last forever, though. It will be lifted once your bankruptcy discharge is entered or your bankruptcy case is dismissed or closed. The IRS may hold your refund so that it can collect from it once the automatic stay is lifted. If you owe child support, they can offset your refund and pay back the individual you owe even if the automatic stay is in place since child support collections are not prohibited during this period. If you’re expecting a large refund, it’s best to talk to your attorney about it.
What are the Automatic Stay Restrictions?
The automatic stay may last for only 30 days after filing bankruptcy if you filed a different case the previous year and dismissed it voluntarily. This restriction was set in place so that debtors can’t file multiple bankruptcies and benefit from the automatic stay. They also need to stop their creditors’ collection efforts.
You may request for the automatic stay period to be extended if you filed a bankruptcy case in the previous year if you can prove that you filed in good faith. You also need to prove to the court that you filed for bankruptcy in good faith if you had two or more cases in the previous cases and dismissed them voluntarily.
You can show good faith by making accurate financial disclosures, showing the receipts of all payments you’ve made to your creditors, and presenting proof that these balances were incurred due to unfortunate circumstances, such as loss of a job.
Creditors may be able also to seek relief from the automatic stay if the secured debt is related to cars or real estate. Likewise, the IRS may ask the court to lift the automatic stay order if they can prove that you committed tax fraud.
Automatic stay only applies to balances incurred before you filed a bankruptcy case and doesn’t include the back taxes you incurred after the filing.
What are the IRS Actions that are Not Affected by the Automatic Stay?
Even if an automatic stay is in place, they can still:
- Conduct a tax audit
- Demand that you file a tax return if you haven’t done so
- File a Notice of Federal Tax Lien or NFTL again
- Keep your tax refund on hold if you need to pay child or spousal support
What is the Series of Events for a Tax Debt Discharged in Bankruptcy?
The IRS will send you a notice for your debt. You’ll continue to receive letters reminding you to pay the amount you owe every few months.
You’ll receive legal notices that may involve garnishment, bank account seizures, and a tax lien.
When you file for bankruptcy, the court will issue an automatic stay order that will prevent creditors from contacting you or collecting the amount you owe.
On your paperwork, you have to list your debt as a priority unsecured debt.
During the 341 trustee meeting, your trustee and creditors will review the paperwork to make sure they’re accurate. They will also ask you questions related to your financial status and bankruptcy petition.
The court will issue a discharge on all eligible debt, and you’ll be notified regarding the discharge within 60 days.
If you have questions regarding an open bankruptcy petition, you can call the IRS Centralized Insolvency Operations Unit’s phone number, which is 1-800-973-0424.
Can You Discharge Tax Liens in Bankruptcy?
If your income taxes qualify for discharge when you file a Chapter 7, federal tax liens that were recorded by the IRS prior to your bankruptcy filing won’t be wiped out. Even if the debt related to the lien is discharged, it will remain on your property and you need to pay it off before the property’s title can be sold or transferred to a new owner. Furthermore, the automatic stay only applies to new lien petitions and not to existing ones.
Should You File for Bankruptcy Before Your Tax Return?
Many people often ask when to file bankruptcy, before or after their tax returns because they’re concerned that the IRS may take their refunds. There are no real benefits for filing your income return after filing bankruptcy. However, you’ll enjoy a few advantages if you do so.
For Chapter 7, your trustee will ask for your most recently filed tax return or ask for an explanation if you’re not current. Then, your trustee will compare the income listed on your bankruptcy filing against your latest return. If you’re eligible for a refund, your trustee will check if it can be exempted and if you claimed the right amount for the tax exemption. If these requirements are not met under this type of bankruptcy, your tax refund will be distributed to your creditors.
You must be current on your tax returns before filing a Chapter 13. You have to submit copies for the last four years to your Chapter 13 trustee. You must do this before the 341 meetings of creditors. During this meeting, you will be placed under oath when you answer the questions of the trustee and creditors regarding your financial circumstances and bankruptcy papers.If you failed to file a return on time (prior to the 341 meetings of creditors), your trustee may file a motion that will give you a certain period to submit your returns. Failing to meet the deadline can result in the dismissal of your case. The IRS bankruptcy department may also file a claim that includes their best estimate of what you owe. The amount declared by that department is usually higher than what you would have owed if you filed your return properly and on time.
Can IRS Debt be Discharged in Chapter 13?
Chapter 13 will help you pay back your debt through a manageable, court-approved repayment plan. Your tax debt will be deemed as non-priority if it meets the criteria listed above. You don’t have to pay off the whole amount since the court will determine how much you can afford to pay and include that in your repayment plan.
It will be treated as a medical or credit card debt and will be included in your Chapter 13 repayment plan, which you need to pay back within three to five years. Any remaining unpaid non-priority debt will be eligible for discharge once your repayment plan comes to an end.
Non-Dischargeable Tax Debts in a Chapter 7 Bankruptcy
The following are tax debts that are not discharged in a Chapter 7 bankruptcy:
- Tax lien
- Property taxes due within one year of your filing
- Excise taxes, custom duties, and certain employee taxes
- Incorrect tax credits or refunds related to non-dischargeable taxes
- Tax penalties incurred for tax debt that was not eligible for discharge
- Tax debt incurred from tax returns that were not filed
- Withholding taxes or trust fund taxes
FAQs
1. What Other Ways Will the IRS Forgive Tax Debt?
Aside from relying on filing for bankruptcy for your tax debt to be discharged, the IRS can forgive your debt through other means. The IRS offers different debt relief options for people who are unable to pay their debts:
- Installment Agreements – It allows you to pay your debt in installments. This option is worth considering if your debt, including interest and penalties, doesn’t exceed $50,000.
- Innocent Spouse Relief – It may help you avoid tax liability for the tax problems caused by inaccuracies or fraud committed by your current or former spouse, to which you know nothing about.
- Offer in Compromise (OIC) – It’s a debt relief program that may allow taxpayers to settle unpaid taxes for less than the amount they owe. Please note that the IRS will only accept an Offer in Compromise request if you have filed all your past returns. Submitting an OIC request doesn’t mean automatic approval. The IRS will evaluate your application and consider several factors, such as your ability to pay.
Currently Not Collectible (CNC) – The IRS may forgive your debt if you can prove that you can’t pay back without causing you to fall into financial hardship.
2. How Do You File Your Taxes After a Chapter 7 Discharge?
Once your bankruptcy case is closed, you can have a fresh start and that still includes filing taxes after Chapter 7 discharge. You are required to report an IRS Form 982 for the tax year when you got your bankruptcy discharge so you can make sure that you don’t pay taxes on any forgiven debt during bankruptcy. It will also help in properly allocating any tax attributes.
3. Does Bankruptcy Clear Property Tax Debt?
Property tax debt may be discharged if you enter Chapter 7. However, it will depend on the age of the debt. It won’t be included when the age of the debt is less than one year.
4. What Kinds of Debts Does Bankruptcy Not Erase?
How does bankruptcy affect taxes? It can discharge tax dues. However, there are those that cannot be erased regardless if you file a Chapter 7 or Chapter 13.
- Child and spousal support – Bankruptcy won’t get rid of your alimony obligation and child support. You need to pay them in full whether you file for a Chapter 7 or Chapter 13 bankruptcy.
- Student loans – You need to pay back your student loans even if you’re filing for bankruptcy. This type of debt can be eliminated only if you can prove that paying it back will cause “undue hardship.”
Other non-dischargeable debts include:
- Debts you failed to include in your application
- Debts incurred for death or personal injury due to driving under the influence
- Penalties and fines incurred for violating laws
Under a Chapter 13 bankruptcy case, you’ll be expected to pay these back in full through the court-approved payment plan. Meanwhile, these debts will remain once your Chapter 7 case is over. An attorney can recommend the best course of action during these instances.
5. What Happens to Non-Dischargeable Tax Debts?
If you file a Chapter 7 bankruptcy, the court’s automatic stay order will prevent creditors from collecting your debt. If the court considers your debt as non-dischargeable, the IRS is allowed to resume their collection efforts.
Under Chapter 13, you can use your payment plan to manage your debt payments but you’ll have to pay the non-dischargeable in full during the repayment period. You can find a law firm that can help you with your non-dischargeable back taxes. Everything you discuss will fall under attorney-client privilege.
6. Can Bankruptcy Help With Your Tax Debts if You Failed to File Your Tax Returns?
No. You have to file your tax returns at least 2 years before lodging an application if you want the income tax debt to qualify for discharge. Creditors may be prohibited from collecting those unpaid amounts due to the automatic stay order but they can petition the court to allow them to do so since you failed to file your returns, making those ineligible for discharge.
Conclusion
If you have income tax debt that you believe you can’t pay back, you can file bankruptcy. Under Chapter 7, they may be discharged if they meet the criteria. The same requirements apply to Chapter 13 bankruptcy but you still need to pay off the tax debt. The court will determine how much you can pay under a new payment plan.
Filing for bankruptcy should be your last resort since it will negatively affect your credit score. You should consider other relief options provided by the IRS.
Not all unpaid taxes can be discharged when you file a bankruptcy case. It’s best to talk to bankruptcy attorneys and seek legal advice. If the IRS filed a tax lien on your property or if you have other issues with your bankruptcy petition, a bankruptcy lawyer can help. Let your bankruptcy attorney get all the information required so they can fully understand your situation. Just make sure that you look for a law firm with experts who are trustworthy, experienced, and known for their professional attorney-client relationship.
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
