Bankruptcy and Taxes: What Can Be Discharged?

Many people incorrectly believe that they cannot discharge unpaid tax debt in bankruptcy. While this is a very complicated area of bankruptcy law, it is possible to obtain a bankruptcy discharge of many tax debts, including the penalties and interest owed thereon. In fact, bankruptcy can be the best available option for individuals with unpaid tax debt to relieve some or all of the financial and personal hardship caused by owing money to the IRS.

Five Criteria for Discharging Tax Debt

Dischargeability of tax debts depends on many factors. The most common tax debt consumers face is unpaid income taxes (form 1040) and its dischargeability generally depends on these factors:

  • The three-year rule. The due date for filing the tax return (including extensions) must have been at least three years before the date the bankruptcy was filed.
  • The two-year rule. The actual filing date of a late tax return must have been at least two years before the date the bankruptcy was filed.
  • The 240 days rule. The tax must have been assessed at least 240 days before the bankruptcy was filed, exclusive of the time during which an offer in compromise with respect to that tax was pending plus 30 days, and exclusive of any time during which a stay of proceedings against collection was in effect because of a bankruptcy case plus 90 days.
  • No fraud or tax evasion. The taxpayer may not have filed a fraudulent tax return or have committed tax evasion or willfully attempted to evade the tax.

Timing is everything when trying to discharge a tax debt in bankruptcy. Filing even one day too soon can result in the tax, penalty and interest being nondischargeable. Extensions to file your tax return likewise extend the date you can file a bankruptcy case and receive a discharge of otherwise dischargeable taxes. Therefore, it is imperative that you have an experienced advocate on your side to consider the optimal time to file a bankruptcy case when you owe the IRS.

Repaying Tax Debt in a Chapter 13

Not all consumers meet the requirements to file a Chapter 7 case and sometimes Chapter 7 is inadvisable. In these cases, most have the option of filing a Chapter 13 case instead. Chapter 13 bankruptcy allows you to set up a plan to reorganize all of your debts, which can include discharging or releasing you of much of your debts, including the IRS. Taxes that are dischargeable in a Chapter 7 case are generally dischargeable in a Chapter 13 case. The priority and unsecured nondischargeable taxes can usually be repaid in a Chapter 13 case without further interest or penalty. Additionally, payment of these taxes can be stretched for three to five years to make the repayment affordable.

Consideration of any missed or past due returns is important in timing the filing of a bankruptcy case. Usually it is advantageous to file any past due returns prior to filing a bankruptcy case so that the Chapter 13 plan can effectively deal with any amounts owed by devoting debtor's income to paying the secured and nondischargeable priority tax debt instead of other dischargeable debts. Furthermore, this tax liability could increase the deductions on the means test and make Chapter 7 feasible. Whether to pay priority and secured tax debts prior to filing a bankruptcy must also be considered in relation to the means test. Although the means test is beyond the scope of this article, it is important that you obtain competent legal advice concerning this issue prior to the payment of the debt.

Impact of Federal Tax Liens

A federal tax lien is not avoidable in a bankruptcy case. This means that if the IRS placed a federal tax lien on the taxpayer's property prior to the bankruptcy filing, then that tax lien will remain after the bankruptcy, even if the underlying tax debt was discharged. However, Chapter 13 bankruptcy can be used as a way to repay the secured portion of the tax liability and protect your property from levy and sale by the IRS.

Contact an Experienced Bankruptcy Attorney

As you can see, this area of bankruptcy law is very complex. For more information on discharging tax debt in bankruptcy, contact an experienced attorney today. A bankruptcy lawyers near me can review your case and help you determine whether a Chapter 7 or Chapter 13 bankruptcy may be your best option for dealing with unpaid taxes.