Most taxes can’t be eliminated in bankruptcy, but some can.
If you’ve heard commercials offering the hope of eliminating tax debts in bankruptcy, be cautious. Bankruptcy lawyers regularly answer the question, “Does bankruptcy clear tax debt?” and the answer is always the same. “Sometimes.” The reality is eliminating tax debt in bankruptcy can be complicated. Before you file for bankruptcy, you’ll want to understand:
- when you can discharge a tax debt
- what happens to federal liens, and
- how to manage tax debt using Chapter 13.
By the end of the article, you’ll understand why many filers continue to owe tax debt at the end of a Chapter 7 bankruptcy case and why most Chapter 13 filers must pay taxes in full through a Chapter 13 bankruptcy repayment plan.
When You Can Discharge Tax Debt
If you need to discharge tax debts, Chapter 7 bankruptcy will likely be the better option because it’s a quicker process and doesn’t require debt repayment. But Chapter 7 isn’t available to everyone. You must be eligible for Chapter 7 bankruptcy, and your tax debt must qualify to be wiped out with a Chapter 7 bankruptcy discharge.
Here are the conditions you must meet before eliminating federal income taxes in Chapter 7 bankruptcy:
- The taxes are income taxes. Taxes other than income, such as payroll taxes or fraud penalties, can never be eliminated in bankruptcy.
- You did not commit fraud or willful evasion. If you filed a fraudulent tax return or willfully attempted to evade paying taxes, such as using a false Social Security number on your tax return, bankruptcy can’t help.
- The debt is at least three years old. The tax return must have been originally due at least three years before filing for bankruptcy.
- You filed a tax return. You must have filed a tax return for the debt you wish to discharge at least two years before filing bankruptcy. (In most courts, if you file a late return (meaning your extensions have expired and the IRS filed a substitute return on your behalf), you have not filed a “return” and cannot discharge the tax. In some courts, you can discharge tax debt even if you filed a late return if you meet the other criteria.)
- You pass the “240-day rule.” The IRS must have assessed the income tax debt at least 240 days before you file your bankruptcy petition, or not at all. (This time limit could be extended if the IRS suspended collection activity because of an offer in compromise or a previous bankruptcy filing.)
Even if you meet these conditions, you might be out of luck if the IRS has already put a lien on your property (more below). Also, some jurisdictions have additional requirements.
For instance, in the ninth district, you must file your tax return in a timely fashion, and filing late precludes a discharge. Also, in Chapter 7, if you paid off nondischargeable tax debt using a credit card, the credit card balance will be a nondischargeable debt if a creditor challenges the dischargeability by filing an “adversary proceeding” or bankruptcy lawsuit.
You Can’t Discharge a Federal Tax Lien
Your victory might be bittersweet if your taxes qualify for discharge in Chapter 7 bankruptcy. Why? Bankruptcy won’t wipe out prior recorded tax liens. All Chapter 7 bankruptcy will do is wipe out your personal obligation to pay the qualifying tax and prevent the IRS from going after your bank account or wages.
But if the IRS recorded a tax lien on your property before the bankruptcy filing, the lien will remain on the property. You’ll have to pay off the tax lien before selling and transferring the property’s title to a new owner.
Managing Tax With Chapter 13 Bankruptcy
Filing your tax return might not be as burdensome once you realize that using Chapter 13 bankruptcy to manage your tax debt can be a smart move. Here’s why:
- Dischargeable taxes (generally those older than three tax years) might be forgiven without any payment, depending on the amount of disposable income you have after your reasonable and necessary expenses are deducted from your pay.
- Dischargeable taxes won’t incur additional interest or penalties (but you’ll pay interest on nondischargeable tax).
- You can satisfy an IRS tax lien through the Chapter 13 plan by paying what you owe.
- The IRS is obligated to abide by the plan as long as you include all your outstanding income tax and keep your tax returns and post-petition tax obligations current during your Chapter 13 plan.
- Bear in mind that any nondischargeable tax that won’t go away in bankruptcy (generally, those incurred during the last three tax years) must be paid in full during the three- to five-year Chapter 13 plan. You’ll be caught up on taxes and most or all of your other debt when it’s over.
Unlike Chapter 7, in Chapter 13, you can discharge a credit card balance incurred due to paying off a nondischargeable tax debt. Learn more about tax debts in Chapter 13.
Should I File for Bankruptcy Before or After Taxes?
You won’t gain any real advantage by waiting to file your income tax return until after you file a bankruptcy case. But, there are many reasons you’ll want to be current when filing your Chapter 7 or Chapter 13 matter.
Tax Returns and Chapter 7 Bankruptcy
When you file for Chapter 7 bankruptcy, the trustee assigned to oversee your case will ask for your most recently filed tax return. That doesn’t necessarily have to be the tax return for the last tax year, but the trustee will ask for a written explanation if it isn’t the most recent return.
The trustee will compare the income you report on your return to the amount listed in your bankruptcy paperwork. If you show that you’re due a refund, the trustee will also want to check that you have the right to protect or “exempt” it and that you’ve claimed the proper exemption amount. If not, you’d be required to turn the refund over to the trustee, who would, in turn, distribute it to your creditors.
Many people plan to use the return for necessary items such as living expenses before filing a bankruptcy case. If you choose this approach, keep records of your expenditures.
Tax Returns and Chapter 13 Bankruptcy
You must be up to date on your tax returns before filing a Chapter 13 case, but the rules allow you a little wiggle room. You’ll provide copies of the returns for the previous four tax years to the Chapter 13 trustee before the 341 meeting of creditors (the hearing that all filers must attend).
If you’re not required to file a return, your trustee might ask for a letter, an affidavit, or a certification explaining why. Sometimes local courts will impose additional rules for documents in their districts.
If you owe the IRS a return but don’t file it before your 341 meeting of creditors, things can happen to derail your case.
- A motion. The trustee will file a motion giving you a brief period to provide your returns. If you miss the deadline, the court can automatically dismiss your case, leaving you no chance to plead your case to the judge.
- A substitute return. The IRS might file a “best estimate” claim based on your past income. The problem? IRS estimates are almost always higher than what you’d owe after filing a proper return.