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. There are types of tax, such as property tax and employment tax, that are immune to bankruptcy. However, 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. Plus, take a closer look at the bankruptcy options as well as alternatives that may better suit your situation.

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 and discharge tax debt with a bankruptcy alone.

Do yourself a favor and hire a tax debt relief expert or a bankruptcy lawyer. It’s 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 a tax relief program.

How to qualify

First things first, you must meet the following six requirements to discharge a tax debt.

1. The taxes you owe must be income taxes.

You can only discharge income taxes through bankruptcy. Other types of taxes, such as those for payroll or property, are 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, 2018, you can only discharge tax debts that were due before November 1, 2015. 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.

Tax fraud vs. tax evasion 

Tax fraud and tax evasion are tax crimes punishable under criminal and civil laws. But what is the difference?

Tax fraud is an illegal intentional attempt to defraud the IRS or evade tax laws. Tax evasion is a subset of tax fraud and is the illegal underpayment or nonpayment of tax. This can occur due to reporting expenses that are illegal, not reporting income, or not paying taxes owed to the IRS. The IRS does not investigate many cases when you consider the number of tax returns filed, but its conviction rate is high.

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.

Chapter 7 vs. chapter 13 bankruptcy

Both Chapter 7 and Chapter 13 can enable you to discharge income tax debt. Which is better for you? Here is a closer look at the pros and cons to consider.

Chapter 7

Chapter 7 bankruptcy provides a full discharge of allowable debts. You have to give all of your assets to the court and they will liquidate them to pay your debts. If you have no assets or don’t have enough to cover the debt, the rest will be discharged.

Allowable debts are those that are unsecured such as medical bills and credit cards. To qualify, you must meet the income requirements. The process usually takes three to four months.

This route will allow you to discharge qualifying debts and start fresh in a relatively short amount of time.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of a Chapter 7 bankruptcy.

Pros
  • Allows you to discharge debts to start over.
  • State exemptions allow you to keep some property within the allowable limits.
  • Stop collection activities from lenders.
  • Qualifying tax debts can be discharged within months.
Cons
  • Must meet income requirements.
  • Will remain on your credit for 10 years.
  • Lose non-exempt items such as property, investments, credit cards, collections, family heirlooms, a second vehicle, etc.

Chapter 13

Chapter 13 bankruptcy is a reorganization of your debts in which you repay them in-full or in-part over a period of time. This option is for you if your income is too high to qualify for Chapter 7 but you need debt relief.

You can keep your property such as a home or car and catch up on the payments with this payment plan. Whereas in Chapter 7, there is no way to catch up on missed payments and avoid repossession or foreclosure.

The payment plans usually span three to five years.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks of a Chapter 13 bankruptcy.

Pros
  • Recent income taxes (less than three years old) can be included in a payment plan. This can reduce negative actions from the IRS.
  • The IRS/state will usually not take action against you if you are in a bankruptcy payment plan.
  • Remaining taxes may be discharged upon completion of the payment plan.
  • Chapter 13 is easier to qualify for than chapter 7.
Cons
  • You pay a portion of the debts you owe rather than discharging them all.
  • If you don’t complete the payment plan, you risk not discharging your debts.
  • The process takes longer; three to five years.

In most cases, a chapter 7 bankruptcy will provide a quicker way to discharge your tax debts with less risk. However, a Chapter 13 bankruptcy can help you to manage more recent tax debts and also may be the only option available to you if your income is too high.

Alternatives to filing bankruptcy for tax debt

What else can you do aside from filing bankruptcy?

Offers in compromise

The offer in compromise (OIC) option enables a taxpayer to present an offer to the IRS to pay less than the full amount of taxes they owe. It’s available to people who can not pay their full tax liability or who will suffer financial hardship by doing so.

The IRS will generally accept an OIC when it is the most they can expect to collect within a reasonable amount of time. However, to qualify, you must be current with all of your filing and payment requirements. Further, you can’t be in an open bankruptcy proceeding.

Installment agreements

Installment agreements are a long-term payment plan between a taxpayer and the IRS. The taxpayer agrees to pay the amount they owe within an extended timeframe.

Long-term payment plans are those which extend longer than 120 days. You can apply online, by phone, by mail, or in-person. You do have to pay a setup fee. Plus, interest and penalties will still accrue until the balance is paid in full.

To apply online, you must owe less than $50,000 in combined tax, interest, and penalties. Otherwise, you must apply by mail or phone.

Home equity borrowing

If you own a home, you can borrow against your equity to obtain a lump sum. You can then use the lump sum to pay your tax bill. Doing so will settle your debt with the IRS and stop collection proceedings. Plus, it can save you on the expensive interest and penalties that accrue.

Home equity loans and lines of credit typically have low borrowing costs because the debt is secured by your home. However, if for some reason you can not keep up on your payments, your home will be at risk. This can be a good solution in some situations.

Personal loans

A personal loan is another way to move the debt from the IRS to another party. The IRS is not a good debtor to have as they are expensive, aggressive, and powerful.

If you have decent credit, you could get a personal loan and use the proceeds to pay off your tax debt. Then, you can make monthly payments to pay off the loan without accruing penalties and interest.

While there will be interest, you can shop around to find the best rate available to you.

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