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.

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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:

Income taxes can be discharged, but other types of tax debt can’t.

Income taxes qualify for discharge in Chapter 7 or partial payment under Chapter 13. However, you cannot discharge payroll taxes, employment taxes, trust funds faxes, sales tax, and any penalties for non-dischargeable taxes. Property taxes can also qualify for discharge in some cases.

Tax debt that is at least three years old is a good candidate for bankruptcy

The clock begins from the date the taxes were originally due. “New” tax debt from the past two years will not qualify for discharge.

Fraud immediately disqualifies you from discharging that debt.

For a tax debt to be eligible for discharge, you must have filed a tax return correctly. Any attempt to falsify your return or evade paying those taxes means you can’t use bankruptcy to get rid of the debt.

If you filed on time, you’re in the best position.

Federal law requires that you filed your tax return at least two years prior to filing bankruptcy. However, some states require that you filed your return on time. If you never filed and the IRS filed a return on your behalf, that may not count, depending on where you file bankruptcy.

Any debt the IRS assessed at least 240 days prior to the bankruptcy filing qualifies.

The IRS has some specific rules on when the tax assessment occurred prior to your bankruptcy filing, known commonly as the “240-day rule.” However, there are exceptions that can extend the time if you filed an offer in compromise or had a previous bankruptcy petition.

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.

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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.

FAQ

Q:What happens to property taxes if I file bankruptcy?

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A: Property taxes have a shorter window of how old the debt needs to be if you want to discharge it through a Chapter 7 bankruptcy filing. If the property taxes are more than one year old. they may be included for discharge. If they are less than a year old, they cannot. In a Chapter 13 filing, property taxes that are less than a year old would be considered a priority debt, so they must be paid in full. Property taxes that are more than a year old would be a nonpriority debt, so they would be included in your payment plan.

Q:Can bankruptcy help with unfiled taxes?

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A: No. If you did not file your tax return at least two years prior to the date you filed for bankruptcy, then those debts will not qualify for discharge. However, the automatic stay may temporarily stop the collection actions on those debts. However, the IRS has the right to petition the court to allow them to continue collection actions on those debts.

Q:If I use a credit card to pay my taxes, can that debt be discharged?

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A: This can get complicated. Bankruptcy law states that you cannot discharge a debt incurred by paying a non-dischargeable debt. According to the letter of the law, whether you can discharge the credit card debt depends on whether the original tax debt would qualify for discharge. If you used a credit card to pay off income tax debt that was more than three years old and you filed the original return on time, that debt would qualify for discharge. If you used a credit card to pay off new income tax debt that’s less than three years old, it would not qualify.

The same would be true for a debt consolidation loan. While an unsecured debt consolidation loan would usually qualify for bankruptcy, if you used a portion of that loan to pay off non-dischargeable tax debt, then that portion of the loan would not qualify for discharge.

However, bear in mind that this issue is dependent on someone going back to check what the credit card payments were used to cover. In many cases, that may not happen.

We spoke to consumer debt expert Steve Rhode, the Get Out of Debt Guy who said, “I wish the issue of the discharge of credit card debt for tax payments was a clearcut situation. The rules say the debt can’t be discharged but in practice it typically is. This is another reason you should work with a local bankruptcy attorney to file. Local practice and outcomes will help you to really understand how otherwise protected expenses on credit cards are really handled where you live. For people that might decide incorrectly to file their own bankruptcy, they could easily make the wrong assumption about how the bankruptcy court really and practically handles this.”

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Article last modified on October 8, 2020. Published by Debt.com, LLC