Are you thinking about filing for bankruptcy to eliminate unpaid tax debt? Proceed with caution before you call the toll-free number you heard on the radio advertisement or visit the company’s website claiming they can lend a helping hand. It’s not as easy as it sounds, and you’ll likely have to repay what you owe at some point.
Can You File Bankruptcy on Taxes?
While it’s true that bankruptcy can sometimes clear outstanding tax debt, the rules around this are complex and dependent on a number of factors. For instance, filing for bankruptcy can only help you clear federal or state income tax debts. Other types of tax debts, such as payroll taxes and property taxes, will have to be paid regardless of the bankruptcy filing.
Chapter 7 bankruptcy is the most viable option for individuals and businesses trying to clear tax debt through bankruptcy filing, but it’s relatively challenging to meet the qualification criteria.
For instance, you must prove that your income is low enough for you to qualify for Chapter 7, which typically means that your income for the past six months should have been, on average, lower than the median income for your state.
Furthermore, before filing for Chapter 7 under the U.S. Bankruptcy Code, you’ll have to complete a credit counseling course designed to help evaluate your finances and enable you to find an alternative to bankruptcy. You’ll also have to surrender all non-exempt assets to discharge tax debt as well as any debts incurred through medical bills, credit cards, and personal loans. Only after this will you be allowed to file for Chapter 7 bankruptcy.
Most types of bankruptcy, moreover, will only clear income tax debt that’s at least three years old, meaning that the amount being discharged was for a tax return due at least three years before you filed for bankruptcy. And even if your tax debts meet these requirements, you may still end up having to repay some or all of it through a Chapter 13 bankruptcy repayment plan.
When Tax Debt Can Be Discharged in Bankruptcy
Here are the criteria to get a tax debt discharged in bankruptcy:
- The tax debt to be discharged was filed and assessed by the IRS at least three years prior to the date you’re filing for bankruptcy.
- The balance due cannot be associated with a fraudulently-filed tax return or a willful attempt to evade taxation.
- The tax returns for the applicable tax debt were filed at least two years before the bankruptcy filing (or it’s been two years since the returns were filed with the IRS).
- The tax debt is at least 240 days old.
- Certain types of tax debt cannot be discharged through filing for bankruptcy. These include fraud penalties and payroll taxes.
- You cannot discharge your tax debts via bankruptcy unless you’ve filed all the required tax returns for the years during which you incurred the tax debt.
A bankruptcy attorney or a representative from a reputed tax debt relief company will be able to give you more details about all the specific rules and requirements you’ll have to fulfill to discharge your tax debts in bankruptcy.
Can Federal Tax Liens Be Discharged in Bankruptcy?
No, federal tax liens cannot be discharged in bankruptcy. While Chapter 7 could get you out of the hot seat with the IRS and temporarily stop collection activity, the lien will stay on your property until you’ve paid off the tax debt. This means you won’t be able to transfer your property to a loved one or sell it without coming up with the funds owed to the IRS.
Chapter 7 Bankruptcy
As mentioned earlier, you can file to have your federal income tax debt discharged under Chapter 7 bankruptcy. Unpaid state tax debt could also be eligible for discharge but often is not. Still, you should consult with a tax professional for more information on this subject, as the requirements can vary by state.
Chapters 11 and 13 Bankruptcy
Filing Chapter 11 for business is often referred to as a “plan of reorganization” where creditors like the IRS are paid back a portion of what they are owed over a period of up to 60 months. After that, a portion of the balance will be paid through an installment payment plan, and any unpaid amount could be forgiven by the IRS. Recent rules have been changed to include penalties and interest as a ‘priority claimant,’ however, so the appeal of filing Chapters 11 and 13 on taxes has diminished in recent years.
Chapter 12 Bankruptcy
Chapter 12 bankruptcy is reserved for family farmers and fishermen with unpaid tax debt. It was designed to help them restructure and repay their tax debts in manageable installments over an extended period of time while keeping their assets and property intact.
However, eligibility for this type of bankruptcy is not automatic even if you’re engaged in the aforementioned industries, as certain requirements must be met to move forward with filing.
Chapter 13 Bankruptcy
Also known as a wage earners plan, Chapter 13 bankruptcy works just like Chapter 11 above but is available to wage earners with regular income. It allows you to repay your taxes through a repayment plan that spans three to five years. But you could still be responsible for the remaining balance once the payment plan ends if you fall under any of these circumstances:
- You owe withholding taxes.
- You owe back taxes and did not file an original return.
- You owe tax debt from a fraudulent return or an attempt to evade taxation.
- The IRS could not file a claim to protect their interests due to delayed notification of the bankruptcy filing.
Filing for Chapter 13 could be quite risky if you aren’t certain you can keep up with the monthly payments, however. The trustee of the bankruptcy could decide to convert your Chapter 13 to a Chapter 7 and liquidate all of your assets to satisfy your creditors should you be unable to make the established payments.
Filing Your Taxes After Bankruptcy
Filing for bankruptcy won’t significantly impact how you file returns in the future. However, you need to keep paying your taxes in a timely manner, even after you’ve filed for bankruptcy, as it’s an essential step towards getting back on your feet financially. You’ll continue preparing and filing Form 1040, but you’ll also need to add IRS Form 1041 (US Income Tax Return for Estates and Trusts) to your list.
You’ll be responsible for Filing Form 1041 if you’ve filed for Chapter 11 bankruptcy. But if you’ve filed Chapter 7 or Chapter 13, a third-party trustee will file the form on your behalf.
This form is required since filing for bankruptcy means a trustee is now handling your assets that are used to remit debt payments.
When filing your taxes after bankruptcy, you may be eligible to claim certain related deductions, such as the expenses incurred during the process of filing for bankruptcy. In some cases, the debts discharged in bankruptcy might be considered taxable income, so be sure to consult an experienced tax professional to determine whether or not this applies to you.
Other Methods To Deal With Tax Debt
Dealing with unpaid tax debt can be stressful, and bankruptcy is usually used only as a last resort. There are other ways to buy time with the IRS, and bankruptcy is very limited in the results it can achieve. It will also severely limit your ability to get loans in the future and will have a major negative impact on your credit score.
Bankruptcy court might be the only viable option for you if you have a large non-tax burden with other creditors (such as credit card debt or personal loans). However, purely tax-driven bankruptcies almost never benefit the debtor financially.
To explore other options for tax relief, you can hire a team of tax professionals to help you leverage options, including installment agreements or offers in compromise. The best course of action would probably be to book a free consultation with a reputed tax debt relief company, as they have a lot of experience helping businesses and individuals negotiate with the IRS to clear their tax debt on a sustainable schedule.
