Bankruptcy and Taxes: What Does and Doesn’t Change?

Filing for bankruptcy has major consequences for an individual’s or business’s tax situation. The interaction between bankruptcy and tax law creates rules governing how tax debts, future tax benefits, and ongoing filing obligations are managed. This process alters how past tax liabilities are resolved and sets new parameters for future tax compliance.

Dischargeable vs. Non-Dischargeable Tax Debts

Filing for bankruptcy does not automatically eliminate all tax debts. The law distinguishes between liabilities that can be forgiven, known as dischargeable debts, and those that must still be paid, which are non-dischargeable. Whether a tax debt can be discharged depends on several factors, including the type of tax, its age, and the filer’s history of compliance.

Chapter 7 Discharges

In a Chapter 7 bankruptcy, assets are liquidated to pay creditors, which can lead to the discharge of certain debts. For federal income taxes to be discharged, they must meet a set of timing rules. First, the tax debt must relate to a tax return due at least three years before the bankruptcy was filed. For example, a case filed on April 16, 2025, could address the 2021 tax year, which was due April 15, 2022.

Second, the taxpayer must have filed the related tax return at least two years before filing for bankruptcy. This prevents discharging taxes for unfiled or very recent returns. Using the same example, the 2021 return must have been filed before April 16, 2023.

Third, the IRS must have assessed the tax liability at least 240 days before the bankruptcy filing. An assessment is the formal recording of the tax debt, often following an audit. This 240-day period can be extended by certain events, like a pending offer in compromise.

Even if all timing rules are met, some tax debts are never dischargeable. Taxes from a fraudulent return or a willful attempt to evade tax cannot be eliminated. Trust fund taxes, which include withheld income, Social Security, and Medicare taxes, are also non-dischargeable.

Chapter 13 Discharges

A Chapter 13 bankruptcy involves a three-to-five-year repayment plan instead of asset liquidation. This structure provides a method to repay tax debt over time. Priority tax debts, like recent income taxes or trust fund taxes, must be paid in full through the plan.

Older income taxes that would qualify for discharge in a Chapter 7 case are treated as general unsecured debts. They are pooled with other unsecured debts and may be paid back at a fraction of the amount owed. Any portion of these tax debts not paid by the end of the plan is discharged.

While a discharge removes the personal obligation to pay a debt, it does not automatically remove a tax lien on property. In Chapter 13, the repayment plan can provide for payments to satisfy the government’s interest in the property. This can lead to the lien’s release upon the plan’s completion.

Handling Cancellation of Debt Income

Outside of a bankruptcy proceeding, if a lender forgives or cancels a debt, the borrower must generally recognize the forgiven amount as taxable income. This is known as Cancellation of Debt (COD) income. For example, if a credit card company settles a $10,000 debt for a $4,000 payment, the $6,000 difference is considered income to the debtor.

Bankruptcy provides a major exception to this rule. Under Section 108 of the Internal Revenue Code, debt that is discharged within a bankruptcy case is specifically excluded from the debtor’s gross income. This means the filer does not have to pay income tax on the debts that are forgiven by the bankruptcy court.

However, this benefit triggers a trade-off. The tax-free cancellation of debt requires the filer to reduce certain tax attributes. This prevents a debtor from receiving a “double benefit” of both debt forgiveness and the full, unreduced value of future tax breaks.

The Impact on Tax Attributes

When debt is canceled in a bankruptcy case, the law specifies a particular order for the reduction of tax attributes. The amount of debt discharged is used to reduce these attributes, starting with the most powerful ones.

The required order of reduction is as follows:

• Net Operating Loss (NOL) from the year of discharge and any NOL carryovers.
• General business credits.
• Minimum tax credit.
• Capital loss carryovers.
• The basis of the debtor’s property.
• Passive activity loss and credit carryovers.
• Foreign tax credit carryovers.

The reduction in the basis of property cannot go below the amount of the debtor’s remaining liabilities immediately after the discharge. This limitation ensures the basis reduction does not create an artificial gain if the property is sold later.

Tax Filing Responsibilities During Bankruptcy

Filing for bankruptcy alters a debtor’s tax filing obligations, with requirements depending on the chapter filed. These procedural changes affect the responsibilities of the individual debtor and, in some cases, a newly created legal entity called a bankruptcy estate.

Chapter 7 and 11

When an individual files for Chapter 7 or 11, a separate taxable “bankruptcy estate” is created from the debtor’s property. This splits the tax responsibilities. The debtor files their personal Form 1040 for income earned before the bankruptcy filing date.

The bankruptcy trustee is responsible for the estate’s tax obligations. The trustee files an income tax return for the estate, Form 1041, if it has sufficient gross income and pays any resulting tax from the estate’s funds.

Chapter 13

In a Chapter 13 bankruptcy, a separate taxable entity is not created. The debtor retains their property and is responsible for all tax filing and payment obligations that arise during the case. They continue to file their annual Form 1040 as usual and must stay current on all taxes that become due during the repayment plan.

Short-Year Election

Debtors in Chapter 7 or 11 cases have an option known as the short-year election, which divides their tax year into two periods. The first short year ends the day before the bankruptcy filing, and the second runs from the filing date to December 31. To make the election, the debtor files a Form 1040 for the first short year by its regular due date.

The strategic reason for this election is to make the income tax liability from the first short year a claim against the bankruptcy estate. This allows the tax to be paid from the estate’s assets, rather than remaining a personal liability of the debtor that must be paid with post-bankruptcy income.