In many cases, a debtor is still liable for tax debt after bankruptcy. However, bankruptcy law allows the discharge of tax debt only in some circumstances. A debtor is more likely to have tax debt discharged in Chapter 7 than in a Chapter 13 bankruptcy. In Chapter 13, tax debt, along with other debt, enters a repayment plan. Chapter 7 bankruptcy, on the other hand, allows a debtor to discharge certain kinds of debt, such as credit card debt and medical bills, and in some instances, federal tax debt.
Bankruptcy and Taxes: Qualifying for Discharge
The determination of whether a debtor can discharge tax debt will depend of the type of tax, how old the tax debt is, if the debtor filed a return, and the type of bankruptcy. Federal income taxes in Chapter 7 are dischargeable if the debtor meets all of the following conditions:
- The discharge is for income taxes: Payroll taxes and penalties for fraud are not eligible for discharge.
- The debtor filed a legitimate tax return: The debtor filed a tax return for the relevant tax years at least two years before filing for bankruptcy.
- The tax liability is at least three years old: The tax debt is from a tax return that was originally due at least three years before filing for bankruptcy.
- The debtor is eligible under the 240-day rule: The IRS assessed the tax debt at least 240 days before the debtor filed for bankruptcy. If the IRS suspended collection activity during negotiation, the applicable date may be extended.
- The debtor did not commit willful tax evasion: Possible evasive actions include changing your Social Security number, your name, or the spelling of your name; repeated failure to pay taxes; filing a blank or incomplete tax return; and withdrawing cash from a bank account and hiding it.
- The debtor did not commit tax fraud: The return contains no information that was intended to defraud the IRS.
Penalties on taxes that are dischargeable are also eligible for discharge. After the discharge of tax liability, a debtor is no longer responsible for paying the taxes and the IRS may not garnish a debtor’s wages or bank accounts.
Bankruptcy and Taxes: Federal Tax Liens
Even if the discharge of tax debt occurs under Chapter 7, if the IRS placed a federal tax lien on the debtor’s property prior to the bankruptcy case, it will remain after discharge. As a result, it is necessary to clear the title by paying off the lien before selling the property.
Bankruptcy and Taxes: Tax Debt Not Eligible for Discharge
The following types of tax debt are not dischargeable in Chapter 7 bankruptcy:
- Tax penalties from tax debt that is ineligible to be discharged
- Tax debts from unfiled tax returns
- Trust fund taxes or withholding taxes withheld from an employee’s paycheck by the employer
A debtor unable to discharge tax debt under Chapter 7 may consider other arrangements, such as entering into an installment agreement with the IRS or making the IRS an offer in compromise which will result in the settlement of the tax debt for less than the amount owed.