Can You Discharge Tax Debt in Bankruptcy?
Understand the circumstances under which tax obligations can be eliminated or restructured through bankruptcy, based on key timing and eligibility factors.
Filing for bankruptcy is a significant financial decision, and its interaction with tax liabilities is governed by a detailed set of regulations. While many assume that tax debts are entirely exempt from the protections of bankruptcy, this is not always the case. It is possible to have certain tax debts discharged, but this relief is contingent upon meeting a series of strict qualifications.
This article will explore the necessary conditions that must be met, the different outcomes under various bankruptcy chapters, and which tax obligations typically remain regardless of a bankruptcy filing.
Qualifying Conditions for Discharging Income Taxes
For federal income tax debt to be eligible for discharge in bankruptcy, it must satisfy several time-sensitive tests. The primary purpose of these timelines is to prevent individuals from using bankruptcy to evade recent tax obligations while offering a path for resolving older, unmanageable liabilities.
The first major hurdle is often called the “three-year rule.” This requirement stipulates that the original due date for the tax return in question must be at least three years before the date the bankruptcy petition is filed. This includes any extensions that were filed. For example, if a tax return for the 2021 tax year was due on April 15, 2022, a bankruptcy petition filed before April 16, 2025, would not be able to discharge that tax debt.
Another condition is the “two-year rule,” which focuses on the actual filing of the tax return. The tax return for the debt you wish to discharge must have been physically filed at least two years prior to filing the bankruptcy petition. A return prepared by the IRS on a taxpayer’s behalf, known as a substitute for return, does not satisfy this requirement.
A further time-based requirement is the “240-day rule.” This rule mandates that the tax must have been assessed by the IRS at least 240 days before the bankruptcy case begins. Assessment is the formal process of the IRS recording the tax liability. This 240-day clock can be paused, or “tolled,” by certain events, such as the submission of an Offer in Compromise or a previous bankruptcy filing.
Finally, the tax debt cannot be connected to any fraudulent activity. If a tax return is determined to be fraudulent, or if there was a willful attempt to evade paying taxes, the associated debt is ineligible for discharge. This applies regardless of whether the other time-based rules have been met. Actions such as using a false Social Security number would fall under this exclusion.
Discharging Tax Debt in Chapter 7 Bankruptcy
Chapter 7 bankruptcy provides a mechanism for eliminating certain debts entirely. When federal income taxes meet all qualifying conditions, they are categorized as general unsecured debts. This places them in the same class as medical bills or credit card balances, meaning they can be completely discharged upon the successful completion of the Chapter 7 case.
The process involves the court-appointed trustee potentially selling non-exempt assets to pay creditors. Once the process is complete, the court issues a discharge order, which formally releases the individual from the personal obligation to pay the qualifying tax debt. This action prohibits the IRS from taking collection actions against future income or assets, such as garnishing wages or levying bank accounts.
A federal tax lien plays an important role in this process. If the IRS filed a Notice of Federal Tax Lien against a debtor’s property before the bankruptcy was filed, that lien can survive the Chapter 7 discharge. While the bankruptcy may eliminate the personal liability to pay the debt, the lien remains attached to the property owned at the time of the bankruptcy filing.
This means that although the IRS cannot pursue the individual for payment, the lien still encumbers the property. If the property is sold, the proceeds must first be used to satisfy the tax lien before the owner receives any funds. The lien secures the government’s claim to the value of that property, even after the underlying tax debt has been personally discharged.
Managing Tax Debt in Chapter 13 Bankruptcy
Chapter 13 bankruptcy operates as a reorganization. It involves creating a repayment plan that lasts between three and five years, during which the debtor makes regular payments to a trustee. The treatment of tax debt within this structure depends on whether the debt is classified as “priority” or “non-priority.”
Priority tax debts are those that do not meet the aging rules required for discharge. This includes income taxes that became due within the three years preceding the bankruptcy filing. These priority tax debts must be paid in full through the Chapter 13 repayment plan.
Older income tax debts that successfully meet all the qualifying conditions are treated as non-priority debts. This classification places them in the same category as general unsecured debts, such as personal loans and credit card balances. These debts are often paid only a fraction of their total amount, with the remaining balance being discharged at the conclusion of the repayment plan.
Tax liens are also handled differently in Chapter 13. A filed tax lien makes the IRS a secured creditor up to the value of the debtor’s property. The Chapter 13 plan must provide for the payment of this secured portion of the tax debt. Any amount of the tax debt that exceeds the value of the property may be treated as an unsecured claim.
Non-Dischargeable Tax Debts
Certain types of tax obligations are excluded from discharge in any bankruptcy chapter, regardless of their age or the debtor’s circumstances. These debts will remain payable even after a bankruptcy case is completed. Other specific taxes, such as property taxes that became due within one year of the bankruptcy filing, may also be excluded from discharge.
A primary category of non-dischargeable tax debt is “trust fund taxes.” These are taxes that an individual or business collects from others to hold in trust for the government. The most common examples are payroll taxes withheld from employee wages and sales taxes collected from customers. The associated liability cannot be eliminated in bankruptcy.
Tax debts associated with unfiled returns are also permanently non-dischargeable. If a tax return was never filed for a particular tax year, the corresponding tax liability for that year cannot be discharged. A substitute return filed by the IRS does not count as a filed return for this purpose.