Bankruptcy & IRS Tax: Types, Requirements, & Discharging

tax bankruptcy

Many taxpayers believe filing for bankruptcy (filing a petition in federal bankruptcy court) is the magic cure for their IRS tax debt issues. Bankruptcy should be a last resort, and most tax resolution firms can reduce the total amount you owe and get you on a payment plan so you can avoid bankruptcy.

Why Should I Avoid Bankruptcy?

Bankruptcy does not always release you from tax liabilities. Bankruptcy often leads to the liquidation (selling) of valuable assets but not in all cases — exemptions are determined by the State usually. Moreover, if you file for Chapter 13 bankruptcy this will remain on your credit report for 7 years and a Chapter 7 stays on your credit for ten years. Bankruptcy can have a much greater negative impact on your financial situation than accounts in collection or delinquencies. When your credit is impacted negatively as such with bankruptcy, getting a credit card, car loan, or mortgage is difficult, and even if obtained, will carry extremely high interest due to the risk you pose to creditors.

Can You Discharge Back Income Taxes In Chapter 7, or 13 Bankruptcy?

When you file for Chapter 7 bankruptcy, typically all income tax debts are discharged or you are not responsible for them if they are not recent (previous year) — but other taxes may remain like payroll taxes, and trust fund taxes. Basically you liquidate non-exempt assets (or assets without a tax lien attached) to satisfy some or all of your back taxes. Whatever is left after the liquidation of assets you are typically not responsible for.

With a Chapter 13 bankruptcy (more popular), some of your back taxes can be discharged but usually they have to be repaid with a payment plan usually over 3-5 years. If your income is less than the state median income, you will get a 5 year payment plan otherwise it is normally 3 years. It is common though even with a tax payment plan that you will end up paying less than you owe. Back taxes related to unfiled or late returns cannot be discharged, nor can penalties under current law in most situations.

Realize when you file for bankruptcy an “Automatic Stay” becomes valid which is a legal term that means that creditors, including the IRS, are limited to debts before the petition. Rarely, does the IRS try to remove this “Automatic Stay,” which can only be approved by a judge.

Taxes and Some Chapter 7 Bankruptcy Requirements To Discharge Taxes:

Income taxes can be discharged in bankruptcy if all of the following conditions are met, otherwise the taxes will be due at the end of the bankruptcy.

  • They are income taxes (not payroll, or debt accumulated from fraud penalties, or trust fund taxes)
  • The taxes were assessed at minimum 240 days before you file for bankruptcy
  • The taxpayer did not commit fraud or try to evade taxes
  • The taxes have to be due three years from the date of your bankruptcy filing (includes extensions)
  • All tax returns were filed at least 2 years before filing for bankruptcy (a substitute return is NA)

    You must also prove to the court that you filed taxes returns for the last 4 years

Chapter 7 Bankruptcy Qualifications (What is Required Just to File for Chapter 7):

  • Taxes for the previous year must be paid before a bankruptcy can move forward
  • Income in last 6 months is not greater than your State’s median (otherwise file Chapter 13)
  • You completed credit counseling with a Federal government agency, and did a budget analysis
  • You cannot pay at least $100 a month over five years (otherwise file Chapter 13)
  • You complete a Statement of Financial Affairs (form required for Bankruptcy court filing)

If filed for bankruptcy in the past, then you need to add 6 months plus the amount of days your previous bankruptcy case took to any of the rules above based on time measures. If you filed for an Offer In Compromise, then the time period from filing to when the IRS disapproved it needs to be added to the 240 day rule above plus 30 days. If you don’t qualify for a Chapter 7 bankruptcy, then look to apply for Chapter 13.

Requirements and Some Details to File For A Chapter 13 Tax Bankruptcy

Chapter 13 bankruptcy filing is more popular than Chapter 7 but usually does not discharge tax liabilities. Here are a few requirements to qualify:

  • All tax returns were filed at least 4 years before filing for bankruptcy (a substitute return is NA)
  • This is not for business taxes or a business (file for Chapter 11 bankruptcy instead)
  • You must disclose all assets, liabilities, and income and you did not commit fraud
  • Your secured debts cannot exceed $1.01 million, and unsecured debts cannot exceed $337k
  • Secured Taxes, taxes with a lien filed against them (if you own property), you agree to pay
  • You complete a Statement of Financial Affairs (form required for Bankruptcy court filing)
  • A court filing fee of $274 dollars is required and taxes from the previous year must be paid
  • You completed credit counseling with a Federal government agency, and did a budget analysis
  • You can pay at least $100 a month or $6k over 5 yrs

A payment plan proposal must be provided to the court that is reasonable and approved by the judge who appoints a “trustee” to look over your case. Creditors and the IRS will show up at the hearing to object to any repayment terms. Realize that interest and penalties stop accruing when you file for Chapter 13, except on secured taxes (taxes with a tax lien secured against personal property).

Chapter 11 and 12 IRS or Tax Bankruptcy Details

Chapter 11 bankruptcy, if you have ever heard it, is for businesses who need to reorganize so they can once again make a profit.
Chapter 12 bankruptcy applies to family farms. With a chapter 11 bankruptcy, if you are business realize that fees for this type of bankruptcy can be upwards of $15,000 dollars and they can last a long time. Unlike a Chapter 13 bankruptcy, interest continues to accumulate with a Chapter 11 bankruptcy.

Tax Traps To Watch Out For:

  • If you already filed Chapters 7, 11, 12, or 13 and you paid less than 70% of what you owed, your creditors will not be able to get another discharge.

  • It is discouraged to file bankruptcy when you can afford to pay the IRS and it should not be your first choice when you cannot pay. If you have enough income or assets to satisfy your debt your bankruptcy will be dismissed and your back taxes will remain.

  • Similarly, your money and assets can be seized to satisfy your irs tax debt if it is discovered that you have enough to pay off your debt.

Overall, bankruptcy is usually not the right choice when it comes to resolving most types of taxes. When you file for bankruptcy you lose many tax benefits. But if you believe that bankruptcy is the right answer for you, it is very important to consult with a bankruptcy attorney or tax attorney.

IRS Bankruptcy Help and Info

Connect with Tax Attorney to Help with Bankruptcy
A tax attorney is the best tax professional to advise you on bankruptcy when you owe IRS tax debt. Consult with them before making the decision, maybe there are better options.

5 Step Process to Pay Back Taxes
General guidelines to follow in order file and pay/resolve taxes owed to the IRS.

How to File Back Taxes

Before you can declare bankruptcy or settle your taxes in anyway, you must have all of your taxes and filed. Once the taxes are filed, a tax amount owed will be assessed and then a resolution can be made.

Ways to Settle Back Taxes Owed

Alternative methods to bankruptcy that may be much more effective thank bankruptcy. If you are considering bankruptcy, it is possible that you may be able to settle your taxes for less than you owe.

Taxes On a Debt Settlement
Understand how the IRS tax on debt that is settled, canceled, or forgiven works. Find out exceptions to reporting settled debt as income on your tax return.

State Income Tax Bankruptcy Details

With state income taxes, things can get a little confusing. Each state will have its own set of rules with regards to unpaid state income taxes and bankruptcy. These different rules apply to the qualifications discussed in the Chapter 7 or Chapter 13 bankruptcy requirements to the left – specifically the 240 day tax assessment rule, the previous 2 year tax return requirement policy, and so on. It is best to work with a professional here if you want to pursue bankruptcy but again bankruptcy should be a last resort as there are other ways to resolve unpaid taxes.