Many people do not realize that tax debts can be forgiven (discharged) in bankruptcy.  Others think that all tax debt can be discharged at any time.  Each viewpoint is partly correct and partly incorrect.  Bankruptcy and tax debts, however, can be tricky and technical.

Below is a quick summary of the ins and outs of discharging tax debts in bankruptcy.  As noted below, bankruptcy can ruin your credit rating for a long time.  Therefore, it is important that you get expert advice before filing bankruptcy.  More than one taxpayer has filed bankruptcy expecting his tax debts to be discharged in bankruptcy, only to discover too late that the debts did not qualify to be discharged in bankruptcy!

Advantages of Bankruptcy

A discharge of debt obtained in bankruptcy means that you do not have to pay the debt.  It is one of the principal reasons for filing a Chapter 7 bankruptcy.

The “automatic stay” stops all creditors, including the IRS, from collecting unpaid debts.  As indicated by its name, the stay against collection activity happens automatically upon filing of the bankruptcy petition.

Disadvantages of Bankruptcy

A bankruptcy petition stays on your credit report for ten years.  This might adversely impact your ability to get credit in the future (but necessarily).  Even if you do not go all the way through with the bankruptcy proceeding (that is to say, you voluntarily dismiss it), the fact that you filed a bankruptcy petition will be on your credit report for ten years.  Lenders treat bankruptcies where no debts were discharged the same as bankruptcies where debts were discharged.  This makes no sense, but it’s true.

An example is where the taxpayer files bankruptcy, discovers that his taxes are not dischargeable, and then immediately has the bankruptcy petition dismissed.  The credit reporting bureaus will report the fact that that the taxpayer filed bankruptcy, and the lenders will not care that no debts were discharged.  The taxpayer’s credit rating is still ruined, even though the taxpayer received no benefit from the bankruptcy proceeding.

Some taxes are not dischargeable in bankruptcy, no matter what.

If you emerge from bankruptcy with unpaid tax debts, the time period in which the IRS has to collect on those tax debts (the statute of limitations) is extended by the bankruptcy.

A Chapter 7 bankruptcy may cause you to lose ownership of some of your possessions, such as real estate, expensive motor vehicles, and investments, although this is not typical.

Recorded tax liens will survive the bankruptcy and continue to attach to the pre-petition property that you retain after bankruptcy.  The Chapter 7 bankruptcy only discharges your personal obligation to pay the debt.  The IRS is free after the bankruptcy to seize assets that are subject to a recorded tax lien, even if your personal liability has been discharged.

Preferential payments can be set aside.  A preferential payment is a transfer of an asset to a third party without adequate consideration, followed within a certain period of time by a bankruptcy petition.  The transferee of the asset can be forced to return the asset to the bankruptcy estate for the benefit of all creditors.

Not Everybody Can File Chapter 7

Not everybody can file a Chapter 7 bankruptcy proceeding.  The rules changed in October of 2005.  Before you may file Chapter 7 you must pass a “means” test.  If you do not pass the means test, you must fill Chapter 13 instead of Chapter 7.  In a Chapter 13 bankruptcy proceeding you will have to pay all or some of your debts.  Don’t file Chapter 7 without knowing whether you pass the means test.

Summary of the Law

Each of the following requirements must be met in order for a Chapter 7 bankruptcy to discharge tax debts:

  • No fraud or willful evasion of taxes.  You cannot obtain a discharge if you file a fraudulent tax return or otherwise willfully attempt to evade paying taxes.  The IRS typically applies this rule only in cases where a fraud penalty has been assessed.
  • Only income taxes.  Only income taxes may be discharged in bankruptcy.  Other taxes, such as excise taxes or estate and gift taxes are not dischargeable. Trust fund penalties and fraud penalties are never dischargeable.
  • The taxpayer must be an individual.  Corporations and other entities liable for income taxes cannot discharge income tax debts in a Chapter 7 bankruptcy.
  • No withheld or collected tax.  Your liability for another person’s taxes are cannot be discharged by your bankruptcy.  The employer portion of payroll taxes is an example.
  • The three-year rule.  The due date for the return, including the due date after filed extensions, must be more than three years prior to the bankruptcy petition.  Do not forget that due dates falling on Saturday or Sundays are actually extended to the following Monday.
  • The two-year rule.  You must have filed the tax return more than two years prior to the bankruptcy petition.  Returns filed by the IRS on your behalf do not qualify.  There is one “gotcha” relating to the two-year-rule.  The IRS has three years to audit and correct a return after the return has been filed.  Thus, it is possible to discharge taxes on a return only to have the IRS assess additional taxes on account of corrections the IRS makes to the return.

What can greatly complicate all this is that certain actions can extend (toll) each of these periods, so none of the above is written in stone.  You need professional help to correctly analyze bankruptcy and tax debts.

Further, discharging the penalties on taxes does not perfectly correlate to the discharge of the taxes.  The Bankruptcy Code has a different section dealing with discharging penalties on taxes, and that section is considerably more complex and beyond the scope of this website:  Sections 507(a)(8)(A)(i) versus 523(a)(7).