Can You File Bankruptcy on Taxes Owed?

Filing for bankruptcy can offer a fresh start for individuals burdened by debt, but discharging tax obligations is often misunderstood. While certain tax debts can be eliminated, the conditions are highly specific and differ significantly from other types of debt. Understanding these precise conditions is important for anyone considering bankruptcy for outstanding taxes.

Criteria for Discharging Tax Debt

Discharging income tax debt in bankruptcy involves meeting several strict conditions, commonly referred to as the “3-2-240 day rules.” These rules apply to income taxes, as other types of taxes, such as payroll taxes or fraud penalties, are generally not dischargeable.

The “three-year rule” stipulates that the income tax return related to the debt must have been due at least three years before the bankruptcy petition date. This calculation includes any extensions granted for filing the return.

The “two-year rule” requires that the tax return for the debt in question must have been filed at least two years before the bankruptcy filing. A substitute return filed by the tax authority typically does not count for discharge purposes.

The “240-day rule” mandates that the tax must have been assessed by the tax authority at least 240 days prior to the bankruptcy filing. This period can be extended if the tax authority suspended collection activities due to an offer in compromise or a previous bankruptcy filing.

Beyond these timing requirements, the tax debt must not be associated with a fraudulent tax return or any willful attempt to evade taxes. If a tax authority determines that the debt arose from such actions, it will not be dischargeable in bankruptcy. To determine if a tax debt meets these criteria, individuals need records of tax return due dates, actual filing dates, and assessment dates, along with correspondence from the Internal Revenue Service (IRS) or state tax agencies.

Bankruptcy Chapters and Tax Debt

The treatment of tax debt varies significantly between Chapter 7 and Chapter 13 bankruptcy proceedings. Chapter 7, often referred to as liquidation bankruptcy, allows for the discharge of certain eligible income tax debts that meet the criteria outlined previously. If the income tax debt satisfies the age and filing requirements, the personal obligation to pay that specific tax is eliminated. However, not all tax debts are dischargeable in Chapter 7; for example, payroll taxes and most property taxes generally cannot be eliminated.

In contrast, Chapter 13 bankruptcy involves a reorganization and repayment plan, typically spanning three to five years. While recent or non-dischargeable priority tax debts must generally be paid in full through this plan, older, dischargeable non-priority tax debts may be treated similarly to other unsecured creditors. A portion of these non-priority tax debts might be discharged at the end of the repayment period, depending on the debtor’s disposable income and the plan’s terms.

Chapter 13 offers a structured approach to managing tax debt, allowing individuals to catch up on delinquent taxes over time under court protection. This can provide relief from aggressive collection actions, such as wage garnishments or levies, while the debtor works through the repayment plan. Even if a tax debt is not fully discharged, Chapter 13 can consolidate multiple years and types of tax debt into a single, manageable payment plan.

Steps to Address Tax Debt in Bankruptcy

Addressing tax debt effectively within a bankruptcy proceeding requires careful preparation. Before filing, gather all pertinent tax documents, including copies of tax returns, notices of assessment, collection notices from the IRS or state tax authorities, and records of any tax payments. This helps in accurately completing bankruptcy schedules and assessing dischargeability.

During the bankruptcy filing process, properly list all tax authorities, such as the IRS and state tax agencies, as creditors in the bankruptcy schedules. This includes providing accurate amounts owed and specifying the type of tax debt. The bankruptcy court will then issue a notice of the bankruptcy filing to these tax authorities, which triggers an automatic stay, temporarily halting most collection activities.

In some cases, an adversary proceeding might be necessary within the bankruptcy case to formally determine whether specific tax debts are dischargeable, particularly when there is a dispute with the tax authority. Debtors may need to interact with tax authorities to provide requested documentation or clarify tax history.

Dealing with Non-Dischargeable Tax Debt

Even if tax debt is not dischargeable through bankruptcy, either because it does not meet the specified criteria or due to the chosen bankruptcy chapter, several options remain for resolution.

One common approach is to arrange an installment agreement with the tax authority. This allows taxpayers to make monthly payments over an extended period, typically up to 72 months, to pay off their outstanding balance, including penalties and interest. Eligibility depends on the amount owed and the taxpayer’s ability to pay, with streamlined options available for those owing less than $50,000.

Another alternative is an Offer in Compromise (OIC), which allows qualifying taxpayers to settle their tax debt for a lower amount than what is originally owed. The tax authority evaluates the taxpayer’s ability to pay, income, expenses, and asset equity to determine an acceptable settlement amount. An OIC is generally considered when full payment would create significant financial hardship, and the tax authority believes it is the most it can collect.

While bankruptcy can discharge the personal obligation to pay a tax debt, pre-existing tax liens on property generally survive the bankruptcy process. The lien remains attached to the property, and if the property is sold, the tax authority may still claim proceeds to satisfy the lien. In Chapter 13 bankruptcy, non-dischargeable priority tax debts are typically paid in full through the repayment plan.