Are you struggling with tax debt and facing bankruptcy? You may breathe a sigh of relief to know that you can sometimes eliminate tax debt with bankruptcy and get the debt relief you have been searching for. Whether you can avoid paying Uncle Sam depends on a few factors, though.
There are two main types of bankruptcy in the United States that you should be aware of: Chapter 7 and Chapter 13 bankruptcy. Both allow you to reduce or eliminate tax debt and other kinds of debt, but there are some major differences in how the two operate and who is eligible for each one.
Chapter 7 and Chapter 13 bankruptcy
You might be wondering what the difference is between these two main types of bankruptcy. In short, Chapter 7 is known as liquidation bankruptcy, and Chapter 13 is known as a reorganization bankruptcy.
Chapter 7 bankruptcy: The Details
In Chapter 7 bankruptcy, the debtor (person who owes money) liquidates or sells nearly all of their personal assets to pay off the balance of their debts. Certain property is exempt from liquidation. For example, you are entitled to keep a portion of the following up to a certain value:
- Your homestead
- Your motor vehicle
- Personal property
- Retirement accounts
- Health aids
Once your items have been sold and the proceeds have been used to pay down your debt, the rest is discharged, meaning you do not have to pay it, and the creditor cannot continue to pursue you for it. This is generally intended for lower-income debtors to help give them a means to not stay in debt forever.
Chapter 13 bankruptcy: The details
In Chapter 13 bankruptcy, the debtor does not have to sell any of their personal property or possessions. Instead, they are assigned a payment plan to pay down their debts. Each payment plan will depend on the ability of the bankruptcy lawyer to represent their specific client and will vary on a case-by-case basis.
This Chapter 13 paydown plan is court-mandated, meaning the debtor is legally obligated to follow it, or they could face further penalty. This paydown plan is generally three to five years. You must pay the entire amount on time and in full every month. Once completed, it may result in a discharge of all eligible debt, including medical debt, tax debt, or any other unsecured loans.
Chapter 11 bankruptcy is best for businesses, but individuals can also apply
Whereas Chapter 7 and Chapter 13 bankruptcy are for individuals, Chapter 11 bankruptcy is tailored towards businesses and business owners. It is very similar to chapter 13, as it is also a reorganization plan to pay down creditors over a longer period of time. It is substantially more expensive than Chapter 7 or Chapter 13, as well. Individuals can also file for Chapter 11 bankruptcy and generally do so only when their debt exceeds the limits established by Chapter 13.
Which type of bankruptcy discharges debt fastest?
There is a major difference in the amount of time it takes to discharge debt through each of the options above. When you file for Chapter 7 bankruptcy, debt can be discharged in a matter of only a few months. With Chapter 13 bankruptcy, the debtor must follow their payment plan flawlessly for several years. Since Chapter 7 bankruptcy is the faster and more common option, we’ll focus our attention on that for the remainder of the article.
Chapter 7 bankruptcy requirements
Not everyone can get rid of tax debt with Chapter 7 bankruptcy. According to Mark Billion, CEO of BankruptcyAnywhere.com, you must meet several criteria to qualify.
There’s the 3-2-1 rule for bankruptcy and taxes. The taxes need to have been due three or more years ago, filed more than two years ago, and assessed more than 240 days (one year) ago.”
Says Billion, “There’s the 3-2-1 rule for bankruptcy and taxes. The taxes need to have been due three or more years ago, filed more than two years ago, and assessed more than 240 days (one year) ago.” You also qualify if the taxes have never been assessed.
Discharge Doesn’t Apply to All Tax Debts
Dismissal of taxes owed only applies to income tax debt. Says Billion, “Remaining financial obligations, like payroll taxes, cannot be discharged in bankruptcy.” In addition, warns Billion, “File your taxes on time. Late-filed returns are often not dischargeable [able to be forgiven].”
Beware of Fraud and Additional Requirements
If you filed a fraudulent return or otherwise evaded paying your taxes, you don’t qualify for IRS tax debt forgiveness. Additionally, if your tax debt isn’t at least three years old or it does not meet the 240-day rule, you won’t qualify either.
How Chapter 7 bankruptcy works
Bankruptcy proceedings start when you file a bankruptcy petition with the bankruptcy court in the area where you live. When you file your bankruptcy petition, you must also provide additional information, including the following:
- Your assets and liabilities.
- Your current income and expenses.
- An explanation of your current financial situation.
- Current contracts or leases.
- Recently filed tax returns.
Fees are also due when you file for bankruptcy. They are generally a few hundred dollars depending on where you live. The fee may seem expensive, but it is certainly worth it if it allows you to discharge tax debt that could total many thousands of dollars.
How to qualify for a bankruptcy discharge of tax debt
You must meet the following six requirements to discharge tax debt by filing for bankruptcy.
1. The taxes you owe must be income taxes.
You can only discharge federal or state income taxes. Other types of taxes, such as payroll and property taxes are typically not eligible.
2. The due date for filing your tax return must be at least three years ago.
The original due date on your tax return must be at least three years before the date you file for bankruptcy. For example, if you file for bankruptcy on November 1, 2021, you can only discharge tax debts that were due before November 1, 2018. The due date includes any filing extensions.
3. You must have filed your tax return at least two years ago.
The tax return for the debt you wish to discharge must have been filed at least two years before filing for bankruptcy. The time is measured from the date you actually filed the return, not when it was due.
Additionally, if the IRS filed the return for you – called Substitute for Return – you never officially filed. Therefore, you do not meet this test.
4. The tax assessment must be at least 240 days old.
The IRS routinely assesses taxes on unfiled returns. If this happens to you, your tax assessment must occur at least 240 days prior to filing for bankruptcy. If the 240th day prior to the bankruptcy petition falls on a Saturday, Sunday, or legal holiday, then the relevant period is extended back to the prior business day.
Reasons for the tax assessment may include:
- The taxpayer reports a balance due.
- An IRS audit determines a balance due.
- An IRS proposed assessment becomes final.
However, this tax liability cannot be discharged until you file a tax return for the year in question.
5. You can not be found guilty of tax fraud.
You are ineligible for tax-debt bankruptcy protection if you filed a fraudulent tax return. This occurs when you knowingly fail to file your income tax return or falsify information on your tax return. The line between unintentional negligence and fraud is not always clear. That is why many people leave tax preparation to the experts.
6. You cannot be found guilty of tax evasion.
You are ineligible for tax-debt bankruptcy protection if you willfully tried to evade paying taxes. What does the IRS consider as tax evasion? Any type of action where you avoid paying your tax obligation. As you can imagine, there is a fine line between tax mitigation, which is completely legal, and tax evasion, which could land you in jail for a few years. If you have any doubt about how the IRS will interpret your “tax mitigation” strategy, talk to a tax attorney or a tax relief company that employs tax lawyers.
Dischargeable vs. non-dischargeable tax debts
When it comes to your bankruptcy case, not all taxes and debts are created equal. As mentioned above, income taxes can be discharged (removed) in bankruptcy, as can other debts. For example, credit card debt, medical loans, and personal loans can be discharged as well.
However, other taxes and debts, such as student loans, property tax, and employment tax cannot always be discharged. For example, you can have your federal student loan discharged in bankruptcy, but only if you file a separate action, known as an “adversary proceeding.” This requires the bankruptcy court to find that repayment would impose an undue hardship on you and your dependents.
In the case of property taxes, you can remove the personal liability to pay the tax through bankruptcy, but the tax liens on your property will remain. In such cases, you will have to negotiate with your local tax authority for a tax lien removal.
Debt that Chapter 7 bankruptcy cannot discharge
Unfortunately, Chapter 7 bankruptcies cannot remove existing tax liens. Bankruptcy only removes your personal obligation to pay the tax. Tax liens recorded before you filed for bankruptcy remain as long as there is equity in the pre-bankruptcy property.
Disclaimer: If you are considering filing for bankruptcy to resolve tax debt, you need a tax attorney. It is easy to make a serious mistake that could be construed as tax evasion or trigger a tax audit. Although bankruptcy can be an excellent tax relief tool, it will have devastating effects on your credit and reputation. A licensed tax professional can help you determine what is the best tax relief options for you.
What is a federal tax lien?
This is a claim the IRS makes on all your current and future property. It is the first step toward a tax levy, which occurs when the IRS actually seizes your property. You can compare tax liens to when a bank lends you money and takes the title of your home as collateral. If you don’t pay your mortgage, the bank sells the property to cover the debt. In the case of the tax liens, your tax debt is the loan, the IRS is the lender, and all your worldly possessions become collateral.
What Happens to Tax Liens in a Chapter 7 Bankruptcy?
Since these existing tax debts are not discharged when you file bankruptcy, it is important to know what will happen to them. In many cases, individuals are still obligated to pay them, but your bankruptcy filing may buy you some additional time.
Chapter 7 bankruptcies trigger an automatic stay that bars creditors, including the IRS, from trying to collect debts. This can provide you with valuable time to put your financial affairs in order and get straight with the IRS.
Stops Post-Bankruptcy Tax Liens
A Chapter 7 bankruptcy can also bar the IRS from attaching new tax liens on pre-bankruptcy tax debts that have been discharged. This creates a clean slate or “fresh start” that limits the property the IRS can attach to a lien. The IRS may be able to levy property you owned before the bankruptcy, but the new property you acquire after the bankruptcy is in the clear.
Other Ways to Deal with Existing Tax Liens
In addition to the options above, here are a few other ways to eliminate tax liens:
- Pay the entire tax debt and apply for a tax lien release. This would make sense for taxpayers who come out of bankruptcy with assets that exceed the value of their tax liability.
- Negotiate an installment agreement or offer in compromise. A good option for people who want to keep certain assets attached to a lien, but their value is not enough to pay the tax debt in full.
- Redeem specific items on the tax lien. Taxpayers can pay the IRS the value of a specific asset, such as a car or home, as assessed by the bankruptcy court. In exchange, the IRS removes it from the tax lien.
- Wait it out. In other words, do nothing. This may be a smart move if your tax obligation was discharged and the value of the property attached to the tax lien is nominal. It also may be the right move when the statute of limitations on a tax debt (10 years) is nearly over. Remember that certain actions, such as filing for bankruptcy and negotiating an offer in compromise, extend the statute of limitations.
Consult an Attorney Before Making a Decision
Talk to a bankruptcy attorney or CPA before making a decision. Filing for bankruptcy and removing a tax lien are two things you may not want to do by yourself. Click here to receive a free, no-strings-attached consultation with an experienced tax professional.
Drawbacks to Filing for Bankruptcy
While Chapter 7 bankruptcy allows you to start fresh with no debt, the solution has drawbacks. Your credit score will plummet and the bankruptcy stays on your credit report for up to 10 years. [source]
You may also lose important possessions during the procedure. Chapter 7 bankruptcy is known as liquidation bankruptcy. That means that your assets will be sold, and your creditors will receive payment from the sale of your property.
Non-exempt items that can be seized during Chapter 7 bankruptcy include credit cards, investments, and valuables such as stamp and coin collections, family heirlooms, a second home or vacation home, and a second vehicle.
The exempt property you can keep includes vehicles (up to a certain value), most clothing, household goods and furniture, appliances, jewelry (up to a certain value), your home and some of its equity, and pensions.
If you don’t wish to part with your property and your tax debt is several years old, Chapter 7 bankruptcy may not be the best idea. There is a 10-year statute of limitations on tax debt. After 10 years, tax debt is usually forgiven by the IRS. If you’re close to forgiveness, it may pay to wait. Filing for bankruptcy extends the statute of limitations, which also extends your obligation to pay.
Alternatives to Filing for Bankruptcy
Given the drawbacks of a bankruptcy filing, it may be a better idea to find an alternative way to pay off the IRS. The IRS is open to working with you to resolve your tax debt. Read this article for a comprehensive list of tax debt relief strategies.
You can also try for an offer in compromise, which can reduce your tax debt. A payment plan is another option in which you pay off your debt in small chunks over a long period of time. Penalty abatement is another option. This eliminates accrued tax penalties.
Using Bankruptcy to Your Advantage
With the right timing, it is possible to use bankruptcy to block the IRS from filing a tax lien in the first place. Remember, though, that not all income taxes are discharged in bankruptcy. For instance, you cannot discharge income tax debt linked to a tax return you filed less than three years ago.
What Happens When the Bankruptcy is Over?
Once the bankruptcy is over, the IRS can seize (levy) many of the assets you owned when you filed for bankruptcy. In most cases, this is not an issue because taxpayers don’t tend to have many assets lying around after bankruptcy. Unless you owned real estate or retirement funds, the old tax lien wouldn’t affect you all that much. Another point to remember is that bankruptcy law gives debtors exemptions when liquidating their assets in a Chapter 7 bankruptcy.
Does Bankruptcy Clear Tax Debt?
Filing for Chapter 7 or Chapter 13 bankruptcy is a common way to eliminate or reduce tax debt. Owing to the IRS and filing for bankruptcy are two serious financial matters. If you decide to file for bankruptcy to erase or reduce your tax debt, consider seeking professional assistance. Your information will be protected through your attorney-client relationship, and the law firm you hire will represent you to the best of their ability.
Additionally, a tax relief company can help you determine the best way to get debt relief and resolve your tax debt. It is also important to remember that every bankruptcy case is different, and your individual situation likely requires the help of an expert.
The best place to start is first to check whether you qualify for tax relief. Then, make sure you review and compare the top tax relief companies side by side to find the best option for you before you file for bankruptcy.
Julie Bawden-Davis is a widely published journalist specializing in personal finance and small business. She has written 10 books and more than 2,500 articles for a wide variety of national and international publications, including Parade.com, where she has a weekly column. In addition to contributing to SuperMoney, her work has appeared in publications such as American Express OPEN Forum, The Hartford and Forbes.