Does Bankruptcy Clear Tax Debt? – Forbes Advisor

You may have heard that if you’re up to your eyeballs in tax debt to the IRS, bankruptcy won’t help you. That’s true—most of the time.

The nuanced reality is that filing for bankruptcy can clear away tax debt, in some cases. So if you’re struggling with back taxes you can’t pay, here’s how to tell if bankruptcy is an option worth considering.

Bankruptcy and Tax Debt Basics

Filing for protection from your creditors under the federal bankruptcy law will generally stop bill collectors from harassing you, and give you relief from many of your debts. However, tax debt is treated differently from other kinds.

In bankruptcy jargon, taxes are usually treated as a “nondischargeable priority debt.” This means bankruptcy won’t eliminate them, and repayment of the debt is given priority over other creditors’ claims. Still, there are times when taxes can be considered a “dischargeable debt” that can be eliminated with a bankruptcy filing.

Conditions for Discharging Tax Debt

The first requirement for dischargeable tax debt is that it be income tax debt, specifically. This would include unpaid federal and state income taxes but not, for example, back payroll taxes such as withholding for Social Security and Medicare.

A second condition is that the tax debt can’t be too fresh—generally, newer than three years. To be more precise, the original tax return must have been due at least three years before the date of the bankruptcy filing.

Next, you must have filed a valid tax return for the debt at least two years before filing for bankruptcy. And the return must have been submitted on time. If you requested and received extensions and filed by the extension date, that’s considered “on time.” If you filed after the extension date, the return might not be considered valid and the tax debt won’t be dischargeable.

In addition to rules about age of the debt and timing of the return, there’s a requirement that the IRS must have assessed the debt—in other words, recorded it on the agency’s books—at least 240 days before the bankruptcy filing. This requirement may also be satisfied if the IRS has not assessed the debt yet.

If the IRS did assess the debt and then stopped collection due to a previous bankruptcy filing or other cause, the usual 240-day time frame could be extended, potentially making it tougher to discharge the debt.

Note that if you tried to evade taxes or filed a fraudulent return, bankruptcy won’t protect you. The rules say you must have filed your returns honestly. Also know that different court jurisdictions may have other standards for eliminating tax debt through bankruptcy. We’ve run through the major conditions, but local rules may include other requirements.

Last but far from least, it’s vital that the taxing authority, usually the IRS, has not filed a tax lien on your assets. If a lien has been placed, a bankruptcy filing will not lift it. This is one of the most common obstacles to getting relief from taxes through bankruptcy, so it deserves extra attention—and a definition.

At a Glance: Conditions for Discharging Tax Debt

To discharge tax debt through bankruptcy, these requirements must be met:

• It must be income tax debt
• It must be debt that’s three years old or older
• You must have filed a valid tax return for the debt two years before filing for bankruptcy
• The IRS must have recorded the debt at least 240 days before you file bankruptcy (or not assessed it yet)
• You must have filed your returns honestly—no tax evasion or fraudulent returns
• The IRS must not have filed a tax lien on your assets

Can You Discharge a Federal Tax Lien?

While a tax debt is money owed to the taxing authorities, a tax lien is a legal claim against your property. The lien may be placed on all your property, including bank accounts, personal possessions and real estate.

Bankruptcy does not discharge a tax lien. This means the IRS or other taxing authority will still have a claim to your property even if bankruptcy discharges your tax debt.

But once you have filed for bankruptcy, the IRS can’t keep trying to collect on a dischargeable tax debt, even if a lien is in place. This means your bank account can’t be tapped or your wages garnished to collect on the tax debt. You can continue living in a home with a tax lien on it. However, when you sell the home, the tax lien will have to be paid off from the proceeds.

Best Types of Bankruptcy for Tax Debt

Tax debt can be discharged by filing for protection using any of the options available under the federal bankruptcy code. These include Chapters 7 and 13 for most individuals, Chapter 12 for family farms and fishing operations, and Chapter 11, which is mostly for businesses and larger debts.

Chapter 13 is the most common type of individual bankruptcy filing when tax debt is involved, the IRS says. Chapter 13, known as a reorganization bankruptcy, involves making arrangements with creditors to pay off debts over a period of three to five years. By comparison, a Chapter 7 bankruptcy wipes out many debts, meaning they never have to be repaid.

In a successful Chapter 13 filing, the tax debts that are paid off under the reorganization plan and any tax debts over three years old at the time of filing will be discharged. During the payoff period, the taxpayer must file timely returns and pay all new income taxes that come due.

Depending on circumstances, interest and penalties may be discharged with a Chapter 13 filing. Interest on a dischargeable tax also will be erased. Penalties are dischargeable if they are more than three years old.

In a Chapter 7 filing, the debtor sells off most assets and gives the proceeds to creditors. If there are insufficient or no assets to pay creditors, then eligible debts still get discharged by Chapter 7 and creditors receive nothing. Tax debts can be cleared away by Chapter 7 if they are at least three years old and the taxpayer has filed returns for the last four tax periods, the IRS says.

Strategies for Tax Debt Bankruptcy

Patience and timing are essential for eliminating tax debt through bankruptcy. To begin with, a key part of a successful filing is waiting until the tax debt has passed the three-year mark before turning to a bankruptcy court.

You also need to know what the IRS records show about the timing. So, request transcripts of your tax account from the agency. Dates in these documents will help you know whether it’s too soon to file for bankruptcy to deal with your tax debt.

If a tax lien is complicating your effort to eliminate tax debt through bankruptcy, make sure the lien is valid. To be valid, the lien paperwork must accurately name the taxpayer, the tax year for which the debt is owed and the amount of debt that was assessed, among other details. The taxing authority also must have filed the lien in the correct office, which varies by state.

A faulty lien may be invalid and won’t obstruct a bankruptcy.

If Chapter 7 doesn’t appear to be a workable strategy for eliminating tax debt, Chapter 13 may still work. This approach requires that you make payments for three to five years, but provides opportunities to discharge some debt.

Tax Debt Alternatives to Bankruptcy

Bankruptcy isn’t the only option for coping with tax debt. The IRS may be willing to set up a plan allowing a delinquent taxpayer to pay off debt in installments. If tax debt is the main debt you’re dealing with, an IRS payment plan could be as good an option as Chapter 13 —and save you the legal costs.

If you can’t pay off your tax debt with an installment plan, you may instead be able to use the IRS “offer in compromise” program. Here’s how it works: You offer to pay the IRS less than the full amount, and if you qualify, the IRS will forgive the remaining balance. But understand that you can’t make an offer in compromise once you’ve filed for bankruptcy.

Bottom Line

While it’s true that most taxes can’t be eliminated through bankruptcy, some can. Income taxes that were due more than three years ago can be discharged by a Chapter 7 or Chapter 13 filing.

A bankruptcy filing won’t lift any liens that tax collectors placed on your assets, but it will stop further efforts to collect the debt through garnishing your wages or tapping into your bank accounts.