Ultimate Guide to Tax Debt and Bankruptcy

Everything you need to know about tax debt during bankruptcy

Bankruptcy and its effect on tax debt are often misunderstood. You may have heard bankruptcy cannot remove your tax debts. Fortunately, this is not true. Although there are types of tax, such as property tax and employment tax, that are immune to bankruptcy, it is possible to get rid of  income tax debt by filing under one of the many bankruptcy provisions – such as Chapter 7 or Chapter 13. That’s not to say discharging tax debt with bankruptcy is easy or automatic. Not by a long shot. This guide will look at the criteria used to determine whether you can discharge tax debt by filing for bankruptcy.

Disclaimer: This is a disclaimer you need to read

To say that bankruptcy law is complex is an understatement. Combine bankruptcy law with tax law and you have yourself a legal Molotov cocktail. Although it is smart to educate yourself in both tax law and bankruptcy law, it isn’t smart to try to discharge tax debt with a bankruptcy by yourself. Do yourself a favor and hire a bankruptcy lawyer. It is too easy to make expensive mistakes, particularly when you’re also dealing with the IRS. If you can’t afford a tax attorney, then you probably qualify for tax relief program.

Criteria One: Due Date for Filing Tax Return Must Be Three or More Years Ago

Your tax return must have been originally due at least three years before you filed for bankruptcy. This due date includes any filing extensions. Therefore, to determine if your tax debt is dischargeable in bankruptcy, you must have actually filed your taxes three years ago.

Criteria Two: Tax Return Filed 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.

Criteria Three: Tax Assessment 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.

Criteria Four: Taxpayer Not Guilty of 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.

Criteria Five: Taxpayer Cannot be 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 to meet you 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.

Tax Fraud vs Tax Evasion 

Tax fraud and tax evasion are tax crimes punishable under criminal and civil laws. In most contexts, they refer to the same thing. If you want to get technical, tax evasion is a subset of tax fraud and is often used in r They include such actions as:

  • Falsifying tax documents
  • Failure to file a tax return
  • Failure to state the correct income earned
  • Overstating deductions and exemptions
  • Reporting personal expenses as business expenses

Bankruptcy Cannot Eliminate All Tax Debt

Though bankruptcy can discharge much of your tax debt, there are certain instances when a tax liability cannot be discharged. Bankruptcy cannot eliminate:

  • Taxes other than income, including payroll taxes, property taxes, and fraud penalties.
  • A federal tax lien attached to your assets.
  • Tax debts that arise due to unfiled tax returns, unless you subsequently choose to file a tax return for that year.
  • A liability assessed by the IRS under the Substitute for Return program.

Generally, when you owe a debt, the amount canceled or forgiven is considered income. That income is taxable. However, when a debt is canceled under a bankruptcy proceeding, the amount canceled is not income.

Before you choose bankruptcy as your way out of paying back taxes and the associated interest, penalties, and fees, make sure you have all the facts. Bankruptcy is not an action that you should enter into lightly. Speak with a tax professional to make sure it is the right move for you.

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