Does Bankruptcy Clear Tax Debt?

Unpaid tax debt is unique, even when it comes to bankruptcy. While it is possible for IRS or state tax debt to be discharged, that only happens in certain circumstances.  Even the automatic stay that bankruptcy provides has some exceptions that are important to note if you owe back taxes. However, like most debts, bankruptcy may provide a way out of challenges you’re facing with tax debt.

The information below can help you understand what happens to tax debt when you file for bankruptcy and how it may be discharged. If you have questions or want to talk to an expert about your situation, call us or complete the form to connect with a tax or bankruptcy specialist… or both.

Can you file bankruptcy on taxes?

Yes. Filing for bankruptcy may help you get out of back taxes that you owe to the IRS. In fact, both federal and state tax debt can be discharged during bankruptcy in certain circumstances. These five factors determine if your tax debt can eventually be discharged:

Rules for when tax debt qualifies for discharge and when it doesn’t can be complex, particularly on the last factor for when the debt was assessed. This is why it’s advisable to consult a qualified bankruptcy attorney to help you navigate the process.

What happens to tax debt when you file bankruptcy?

Once tax debt meets the requirements above, how it gets handled in bankruptcy depends on which chapter you file.

Tax debt in Chapter 13 bankruptcy

If you file for Chapter 13 bankruptcy where the court trustee arranges a partial repayment plan, then your tax debt will be included in the plan. If it meets the five criteria listed above, then it will be deemed a “nonpriority debt.”

This means it will get treated like credit cards and other debts that are generally easy to discharge. Instead of paying off the full amount, the court will determine how much you can reasonably afford to repay. You will repay some of the debt you or the IRS or your state tax office in your payment plan. Then the remaining balances will be discharged.

If your tax debt does not meet those five, then it may be deemed a “priority debt.” You will still be able to pay it off under your repayment plan. However, it must be repaid in full.

Tax debt in Chapter 7 bankruptcy

With Chapter 7 bankruptcy, known as “straight bankruptcy,” things are more straightforward. If you meet the five criteria defined above, then the tax debt gets discharged. The discharge will also include penalties and interest generated by that debt.

If the tax debt doesn’t meet those criteria, then it and any penalties generated from it will not be discharged. You can still file for bankruptcy and have your other debts discharged, but you will still owe those taxes and must repay them.

How will an automatic stay affect tax debt?

The IRS has some fairly extensive rules on what the automatic stay will and won’t do when it comes to your back taxes and their collection actions. As with any other type of debt, bankruptcy’s automatic stay will prevent most collection actions by the IRS, including:

• Collection letters and balance due notices
• Wage garnishment
• Bank account levies
• Property seizure
• Tax refund offset, where they take your current refund to pay off existing tax debt
• Filing a new Notice of Federal Tax Lien (NFTL)

However, there are other IRS actions that the automatic stay won’t prevent or stop. Even after you file for bankruptcy, the IRS can still:

• Do a tax audit to determine your liability
• Issue a notice of deficiency
• Issue a demand for a tax return if you have not filed yet
• Refile a Notice of Federal Tax Lien (NFTL)
• Intercept your tax refund for past-due child or spousal support

Timing matters

The automatic stay will also not stop any collection actions on “post-petition” tax debt, which is debt incurred after you filed. If you file for bankruptcy in March, then don’t pay your taxes on April 15, then that new debt is not subject to the automatic stay. The IRS can begin collection actions and will not be required to wait for you to receive the final discharge.

This can become even more of an issue with a Chapter 13 bankruptcy since you enter into a 3-5 year payment plan.  You would face possible collection actions on any tax debt incurred within those 3-5 years. If your wages are garnished, it may make it even more challenging to keep up with the monthly payments.

Bankruptcy discharge won’t remove liens

While the automatic stay can stop new lien petitions, existing liens aren’t removed when you file. If you have a federal tax lien placed on any property because of back taxes that you owe, the discharge of that debt during bankruptcy won’t remove the lien. Even if the debt itself is discharged during your bankruptcy, the lien must be paid. Make sure to do this as quickly as possible, so you don’t have issues if you try to sell the property.

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