Bankruptcy and How It Affects Tax Debts
It's a common misconception that you can't discharge tax debts in bankruptcy. It's possible for taxes to be discharged, but a taxpayer must meet certain requirements. Income tax debts might be eligible for discharge under Chapter 7 or Chapter 13 of the Bankruptcy Code, depending on the age of the debts and other criteria.
The Different Chapters of Bankruptcy
There are six numbered chapters of bankruptcy filings. Chapters 7, 11, 12, and 13 are applicable to individuals in different circumstances.
Bankruptcy chapters 9 and 15 aren't applicable to tax debts.
Chapter 7 is sometimes called a "straight" bankruptcy, because it provides for the full discharge of allowable debts. The bankruptcy court effectively takes control of your assets and liquidates them as necessary to pay off as much of your debt as possible. You're no longer responsible for those unpaid balances after your bankruptcy discharged if you don't have sufficient assets to cover all your debts.
Chapter 13 bankruptcy involves a multiyear, court-approved payment plan to repay your debts to the greatest extent possible. The goal is to pay them off in full, but some balances that can't be paid can be discharged.
Chapter 11 allows for debt reorganization and a repayment plan similar to a Chapter 13 filing, but it is generally used by incorporated businesses or individuals whose debt is in excess of the limits for a Chapter 13 filing. That limit is $394,725 as of 2020.
Chapter 12 is intended for family farmers and fishermen who are financially distressed by expenses related to their businesses. It's intended to be a quicker method of filing and designing a repayment plan. There are also limits to how long creditors can collect on debts under this chapter.
Tax Debts in Each Chapter
Tax debts are typically priority debts in all chapter filings. They're addressed and paid first when assets are liquidated in Chapter 7, and they must be included and paid in full in Chapter 12 and 13 payment plans.
Priority tax debts are not dischargeable in Chapters 11, 12, or 13.
You can receive tax refunds while under bankruptcy protection, but they will most likely be directed toward paying your tax debts.
Five Rules to Discharge Tax Debts
Dischargeable tax debts must meet five other criteria.
Tax debts are associated with a particular tax return and tax year, and bankruptcy law lays out specific criteria for how old a tax debt must be before it can be discharged.
Tax debt is dischargeable in Chapter 7 bankruptcies if it meets all five of these rules:
- The due date for filing the tax return in question was at least three years ago.
- The tax return was filed at least two years ago.
- The tax assessment is at least 240 days old.
- The tax return was not fraudulent.
- The taxpayer is not guilty of tax evasion.
Apply these criteria to each year's tax debt to determine whether that year's unpaid balance is dischargeable through bankruptcy. Some of your debts might be eligible, while others might not.
The Return Was Due at Least Three Years Ago
The tax debt must be related to a tax return that was due at least three years before the taxpayer files for bankruptcy. The due date includes any extensions you took, so you wouldn't be able to include a tax debt in a bankruptcy filing until at least October 2024 if you were to request and receive an extension for your 2020 return, making it due in October 2021.
The Return Was Filed at Least Two Years Ago
The tax debt must be related to a tax return that was filed at least two years before the taxpayer files for bankruptcy. The time is measured from the date the taxpayer actually filed the return. In most cases, this covers the same period of time as the due date rule, unless you missed the due date and filed the return late.
Tax debts that arise from unfiled tax returns are not dischargeable. This is an important distinction, because the IRS routinely assesses tax on unfiled returns. These tax liabilities can't be discharged unless and until the taxpayer files a tax return for the year in question.
The Tax Assessment Was at Least 240 Days Old
Again, this often covers the same ground as the first two rules. The IRS must assess the tax at least 240 days before the taxpayer files for bankruptcy. The IRS assessment can arise from a self-reported balance due (such as a tax return you filed), an IRS final determination in an audit, or an IRS proposed assessment that has become final.
In other words, you reported what you owed, or the IRS has officially stated, "This is what you owe."
The Tax Return Wasn't Fraudulent
The tax return cannot be fraudulent or frivolous in any way. You can't try to claim your dog as a dependent, then file for bankruptcy when the IRS calls you on it. You can't be guilty of any intentional act of evading the tax laws.
Other Qualifying Rules
A bankruptcy petitioner is required to prove that their previous four years' tax returns have been filed with the IRS before a bankruptcy discharge can be granted. These four previous tax returns must be filed no later than the date of the first creditors' meeting in a bankruptcy case.
Bankruptcy petitioners are additionally required to provide a copy of their most recent tax returns to the bankruptcy court. Creditors can also request copies of returns, and petitioners must provide a copy to them if they're asked.