Tax Law Issues Related to Bankruptcy
Dealing with tax debt can be stressful, but there are strategies available to reduce it, including installment agreements with the IRS and offers in compromise. Most tax debts are not discharged in bankruptcy, which means you continue to owe them after your bankruptcy case is concluded. However, it is a misconception that you cannot discharge any income tax debts.
There are some limited circumstances in which you can discharge federal, state and local income taxes, as well as penalties and interest, in Chapter 7, Chapter 11, or Chapter 13 bankruptcy. Income taxes are the only kind of tax debt you can discharge under Chapter 7.
Income taxes can be discharged in Chapter 7 bankruptcy if these five rules or conditions are met:
- They are income taxes;
- You did not file a fraudulent tax return or willfully evade taxes;
- You filed a tax return for the debt at least two years before you filed for bankruptcy;
- The tax return was due at least three years before your bankruptcy filing; and
- The IRS assessed your income tax at least 240 days before you filed a bankruptcy petition or has not yet assessed the tax.
With regard to the third requirement, a late return will generally not count as a return for purposes of getting a discharge in most courts, although you should consult a bankruptcy lawyer to evaluate your specific situation. With regard to the last requirement, the 240-day period may be paused while the IRS suspends its collection efforts for certain reasons such as negotiating an offer in compromise with the taxpayer.
What if you qualify for a discharge, but the IRS has recorded a tax lien on your real property? You cannot get rid of a tax lien through Chapter 7 if the lien was recorded against your real property before you filed for bankruptcy. After Chapter 7, you may not be personally liable for an income tax debt associated with a lien, and the IRS cannot go after your bank account or wages, but if the IRS has already recorded a lien on your property, you must pay the lien before you can sell or transfer the property.
Bankruptcy does not provide solutions for all types of tax debt. Recent property taxes; sales taxes; "trust fund" taxes, such as FICA, Medicare, and income taxes withheld from employees; certain employment taxes; and non-punitive tax penalties from non-dischargeable taxes related to an event that occurred less than three years before filing are non-dischargeable. For example, if you are a small business owner, you cannot get a discharge for the sales taxes that your customers paid that you were required to send to the government.
Effect of Chapter 13 on Bankruptcy
In a Chapter 13 bankruptcy case, you will have to repay taxes, but how much you repay depends on the classification of the tax debt as either a priority claim or a non-priority unsecured claim. Priority tax debts include recent property taxes, taxes that you are required to collect or withhold (such as from FICA or Medicare), employment taxes, excise taxes, and non-punitive tax penalties. Priority tax debts must be paid in full, but most bankruptcy filers only pay a portion of non-priority unsecured claims, which may include some tax debts. A debt repayment plan approved by the bankruptcy court will likely be more favorable than the deals you can strike directly with the IRS.
Non-priority unsecured claims must be paid only after priority and secured claims are fully paid. In most cases, you only pay a percentage of the unsecured debt, and this percentage is calculated by looking at the value of your non-exempt assets and considering your reasonable and necessary expenses. A tax debt is non-priority and unsecured if it is income tax that meets the five conditions described above.
However, in order to obtain a discharge of the non-priority unsecured debts at the end of your Chapter 13 plan, you must file all your required tax returns for the tax periods within four years of your filing, and you must continue to file all required returns and pay taxes as they come due during the three to five years that your Chapter 13 bankruptcy is underway. If you fail to file returns or pay current taxes, your Chapter 13 case may be dismissed.
