Does Bankruptcy Clear Tax Debt?
Bankruptcy is often a great option for people who are seeking debt relief. Not every debt, however, gets discharged in a bankruptcy case, and there is a lot of confusion around how bankruptcy affects income tax debt. There are many cases in which people cannot pay their income tax debt, and in this article we will explore the question does bankruptcy clear tax debt?
Eliminating Tax Debts in Bankruptcy
The filing of a bankruptcy, whether chapter 7 or chapter 13 bankruptcy, provides powerful help via two steps: the automatic stay that goes into effect when your case is filed, followed by the discharge injunction that permanently prevents creditors from attempting to enforce or collect a debt against a debtor. For many people, the financial fresh start that comes with filing for bankruptcy is life-changing. This is doubly powerful when it comes to tax debt, since the power of the IRS is far reaching, and tax debts may impact your ability to receive any tax return refunds.
When Can You Discharge Tax Debt?
There’s a lot of confusion about whether a debtor can discharge income taxes in bankruptcy. In fact, many people that have consulted me start with a statement suggesting they heard from somewhere that bankruptcy does not help people with tax debt. This is simply untrue. Tax debts may be dischargeable in bankruptcy, but there are rules around dischargeability of IRS tax debt.
To complicate things a little more, the rules around tax debt relief in bankruptcy cases varies around the country. Before you file bankruptcy to potentially discharge tax debt, be sure that you are familiar with and understand the rules where you live. With that as some context, let’s look at the rules broadly about when you can discharge a tax debt in bankruptcy.
What Determines Whether Your Taxes Can Be Erased? For purposes of this discussion, we will be dealing with income tax debts (1040 debts). Other tax debts, such as for payroll taxes or other fiduciary taxes, are not dischargeable in bankruptcy. To determine whether an income tax liability may be discharged in bankruptcy, the debt must pass a 3-tier test. The statute that defines priority tax debt (which are not dischargeable in bankruptcy) reads:
(A) a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition – (i) for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition ; (ii) assessed within 240 days before the date of the filing of the petition , exclusive of- (I) any time during which an offer in compromise with respect to that tax was pending or in effect during that 240-day period, plus 30 days; and (II) any time during which a stay of proceedings against collections was in effect in a prior case under this title during that 240-day period, plus 90 days; or (iii) other than a tax of a kind specified in section 523(a)(1)(B) or 523(a)(1)(C) of this title, not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case;
Let’s break this down a little. Section (A)(i) means that a tax liability will not be dischargeable if the return for which the debt comes from was due within the 3 years before the filing date. As an example, the deadline for most people to have filed their 2020 federal tax return was May 17, 2021. That means that the earliest a person can file bankruptcy and have a debt from this tax return discharged would be 3 years ahead, or May 18, 2024 (add one day to be confident).
Section (A)(ii), the 240-day rule, means that an assessment has to have been made by the IRS at least 240 before the bankruptcy case is filed. In other words, the IRS has to have had processed your return, and made a determination that a liability is due at least 240 days before you file bankruptcy. You can get this information by obtaining and reviewing a tax account transcript to see when an assessment was issued by the IRS. (The subparts (I) and (II) are tolling events, which would extend that 240 day window. Again, only the account transcript would have information if there are any tolling events that occurred.)
Section (A)(iii) references another statute in the bankruptcy code, which makes income tax debt not dischargeable if a return was not filed (or a substitute return was filed), if there are late returns, or if there was a fraudulent tax return filed.
What does all this mean? The bankruptcy code is meant to be strictly applied, which means that the discharge applies unless it falls under these limited definitions and conditions. So if you have a tax debt that passes all three of these tests (tax return was timely filed, not fraudulent, from a return due more than 3 years ago, and assessed at least 240 days ago), you can confidently presume that the tax debt will be discharged in a chapter 7 bankruptcy case. In summary, you can generally assume taxes will not be dischargeable if:
- the return was due less than 3 years before the date you are filing your case;
- the tax is for unfiled tax returns or some kind of tax fraud based on a fraudulent return or tax evasion;
- the 240-day limit for an assessment has not occurred;
- the taxes are for some type of trust fund taxes, such as sales tax, employment taxes, or payroll tax;
- the liability is for priority debt incurred as a result of fraud, such as fraud penalties
Can Filing Bankruptcy Discharge a Federal Tax Lien?
In some cases, a person may be considering filing for chapter 7 bankruptcy because they have received notice of a federal tax lien. To understand how a chapter 7 bankruptcy affects a federal tax lien, we need to zoom out and examine liens generally.
A lien generally refers to a claim a creditor may have to certain property of a person or entity that is memorialized and recorded by a filing in a clerk’s office. A mortgage, for instance, is a lien against a person’s home. In New York, the holder of a car note gets its lien recorded right onto the title of the vehicle.
Liens that are recorded are generally not dischargeable in bankruptcy. That is, the bankruptcy discharge does not terminate a creditor’s right to enforce that lien against the property it is secured by. For instance, if a homeowner is facing foreclosure, a bankruptcy discharge prohibits the mortgagee bank from enforcing the debt against the homeowner as an individual, but the bankruptcy does not prohibit the mortgagee bank from enforcing the rights it has against the property – the house – because of the lien filed.
Now that we have a better understanding of liens and how they work in bankruptcy, a federal tax lien is no different. A federal tax lien is a notice that is recorded in a clerk’s office that memorializes the IRS’ federal income tax claim against any property the person has in that county. The filing of a chapter 7 bankruptcy case does not discharge or get rid of that federal tax lien.
What About My Tax Refund?
If you owe priority tax debt, then you may also be concerned about the potential for the IRS to take your tax return refund for a future tax return. Any bankruptcy lawyer attorney will share that this is a valid concern. It may take a little planning, but you may be able to protect your tax refund in bankruptcy even if you owe an IRS tax debt.
When you file for bankruptcy relief, all of your property goes into a theoretical estate to be administered by the bankruptcy trustee. This bankruptcy process occurs, regardless of the type of bankruptcy you file. In your personal bankruptcy, you would claim exemptions to remove property from this theoretical estate, and otherwise protect the property. This includes tax refunds. If you’re able to exempt a tax return refund you are expecting, then it will be protected from both the trustee as well as collection actions by creditors.
Tax Debt: Bankruptcy and the Automatic Stay
While the IRS (and other state taxing authorities) generally have greater enforcement powers than a normal creditor, such as a credit card issuer, that enforcement power is reduced under bankruptcy law. Fortunately, the IRS, like any other creditor, is subject to the automatic stay that goes into effect at the beginning of a bankruptcy case, as well as the discharge injunction that goes into effect at the end of a bankruptcy filing.
Immediately upon filing your voluntary petition, you experience bankruptcy relief, as the automatic stay acts to prohibit enforcement or collection activity, regardless of the types of debts, whether credit card debt or federal income taxes. Generally, if creditors want to proceed to trying to enforce or collect a debt, they will file a motion for relief from stay in the court to get a court order giving them permission to proceed with enforcement of the debt.
Very importantly, the automatic stay applies to your property as well. Thus, if you are dealing with a wage garnishment from a creditor or a bank account was frozen, a bankruptcy filer will see that activity stop almost immediately after the bankruptcy petition is filed.
This is why the automatic stay and the discharge injunction are such powerful tools under bankruptcy law for protecting people like you. It can prevent a creditor’s collection efforts, even the IRS, from taking control of your property, which often ends up being any disposable income you may have. Additionally, the bankruptcy code provides for penalties against a creditor that does violate these stays you are entitled to when filing bankruptcy.
How can I notify the IRS that I’ve filed bankruptcy?
When you file for bankruptcy, whether chapter 7 or chapter 13 bankruptcy, you are required to disclose and list all of your creditors in the schedules that are filed in the bankruptcy court. In these documents, you identify your creditors’ names, addresses, and information about the claim, including any identifying info, date of origin, and claim amount. If you owe federal tax debt to the IRS (and/or a state tax authority), you would list and include that information in these schedules.
Additionally, as part of your bankruptcy paperwork, most (if not all) bankruptcy courts require you to prepare and file a creditor matrix. This creditor matrix document is usually a text file, and will just include the names and addresses of all of your creditors. That document will be uploaded to your file as part of your bankruptcy filing.
Creditors, including the IRS, get notified from that filing usually in one of two ways. First, the bankruptcy court will mail a notice to all of the creditors included on that creditor matrix. Thus, creditors may receive a paper notice of your filing in the mail. The second way creditors may be noticed is through a third-party system. These programs electronically scrape the bankruptcy court dockets every day, and if they find a match for one of their accounts, they update their records accordingly. Many larger creditors subscribe to such scraping programs.
You wouldn’t know how a particular creditor, including the IRS, get notified of bankruptcy filings, so be sure to include the claim in your schedules, and to include them as a creditor on your creditor matrix.
Bankruptcy Alternatives: Payment Plans or Offer in Compromise
While bankruptcy may be one of the best ways to deal with tax debt, there are alternatives to filing for bankruptcy. Two such options offered by the IRS are entering into payment plans, and trying to obtain an offer in compromise.
With a payment plan, you simply enter into a repayment plan with the IRS to pay off your federal taxes over a certain repayment period. The IRS offers both a short-term repayment plan and a long-term repayment plan. The short-term repayment plan allows you to pay your tax debt no later than 120 days from the date of the plan. The long-term repayment plan allows you to pay your tax debt beyond 120 days. Each repayment plan comes with different costs and requirements. One of the challenges with both kinds of repayment plans is that the balance continues to build interest, in addition to the fees charged to set up each plan.
Another alternative to deal with your tax debts is an offer in compromise. As stated by the IRS, “An offer in compromise allows you to settle your tax debt for less than the full amount you owe.” Essentially, the IRS will review your financial status, and if they determine that you have a financial hardship, they will accept a payment less than the full amount of your tax liability to cover the full amount. There are certain conditions the IRS examines for someone looking to do an offer in compromise, including limitations on income, assets, and ability to pay, among other things. Some of the drawback of an offer in compromise include that you have to pay in full whatever amount the IRS agrees to accept. Another drawback tends to be that the amount you will be paying in an offer in compromise will generally be more than you would pay a bankruptcy lawyer to file your case, yet the offer in compromise doesn’t deal with other debts you may have, such as other unsecured debt and medical bills, as well as secured debts you may be struggling with.
Contact the Law Office of Richard Kistnen Today to Discuss Your Tax Debt Problems with an Experienced and Affordable Bankruptcy Attorney!
If you’re struggling with debt, including and especially tax issues, chapter 7 or chapter 13 bankruptcy may be the answer you’re looking for. One of the big questions many people facing IRS tax debt (which is a priority debt) have is does bankruptcy clear tax debt? Filing for bankruptcy may discharge tax debts, but there are things to consider and analyze. Because of the power of the IRS, you don’t want your tax problems to grow worse and worse. To find out more about how a bankruptcy filing can provide tax debt relief from your unpaid taxes, click here to book your no-obligation bankruptcy consultation, or call (718) 738-2324 today!