Learn When and How Bankruptcy Can Help With IRS Tax Debt
Taxes are complicated. Bankruptcy is complicated. So, what do you get when you combine the two? You get something that’s even more complicated. This is why the answer to the commonly asked question, “Does bankruptcy clear IRS debt?” isn’t so simple. That being said, as a general rule, most tax debts can’t be discharged through bankruptcy, but if you’re dealing with old income tax debt, you may be able to get it discharged.
In this article, we’ll explain how bankruptcy treats IRS tax debts, including what debts can be discharged through bankruptcy and what other options might be available to deal with tax debt that can’t be removed through bankruptcy. To get help now, contact us at Wiggam Law today to get help now.
A Bankruptcy Overview
The most common type of bankruptcy is Chapter 7, also known as a “liquidation bankruptcy.” Here, most of the filer’s debts are wiped away (discharged), although a bankruptcy trustee may sell the filer’s eligible property to use the proceeds to partially pay back creditors.
Chapter 7 is typically the fastest and least expensive bankruptcy option available. However, only filers who can pass the “means test” will qualify for Chapter 7 bankruptcy. To pass the means test, the filer must demonstrate that they don’t have the financial resources to pay back some of their debts. If a filer fails the means test, they may still be eligible for bankruptcy relief under a different chapter instead.
Chapter 13 bankruptcy (also known as a “reorganization bankruptcy”) is the second most common type. It differs from Chapter 7 in that instead of liquidating eligible assets. The filer reorganizes their debts to try and pay back some or most of their debts through a proposed repayment plan. Most repayment plans last about three to five years, and any eligible debts remaining after the repayment plan is over will be discharged.
Chapter 13 bankruptcy is only available to individuals, so if a business (that’s not a sole proprietor) wants to file bankruptcy that involves reorganization, it must file Chapter 11 bankruptcy. Chapter 11 bankruptcy allows businesses and some individuals to continue operating during the bankruptcy process, although it will normally be more expensive than Chapter 7 or 13.
In most years, Chapter 7 and 13 bankruptcy cases make up more than 90% of all bankruptcy filings in the United States. Therefore, this article will focus on these two types of bankruptcy filings when examining what happens to IRS tax debts during the bankruptcy process.
How Bankruptcy Treats IRS Tax Debt
Under a Chapter 7 or 13 bankruptcy filing, only income taxes are usually eligible for discharge. In some cases, the interest and penalties attached to the underlying income tax debt can also be discharged.
Most other types of tax debts cannot be discharged in bankruptcy. These include payroll taxes, employee trust taxes, and property taxes. Additionally, suppose the unpaid income taxes were part of an attempt to commit tax fraud or tax evasion. In that case, those taxes (and any fraud penalties imposed on the taxpayer) aren’t eligible for bankruptcy discharge.
Other Tax-Related Debts That Can’t Be Discharged
If you’re considering filing for bankruptcy to eliminate one or more tax debts, there’s a reasonable chance that the IRS has started the tax collection process with you. This might include sending you tax collection letters and notices or placing a tax lien on your property.
Even if the underlying tax debt goes away with bankruptcy, a lien placed on your property by the IRS can remain. The IRS may no longer have the legal right to try and collect the now-discharged tax debt, but they still have their legal claim to the property that’s subject to the tax lien.
Another nuance of the bankruptcy process and tax debts is credit card debt, which is used to pay taxes and is not eligible for bankruptcy discharge. Because the IRS allows you to pay your taxes with a credit card, and unsecured credit card debt is one of the most popular types of debt discharged with bankruptcy, it might be tempting to pay your otherwise nondischargeable tax debt by credit card. Then, when your credit card has a balance you can’t pay, you file for bankruptcy to discharge that credit card debt.
This plan sounds great but doesn’t always work. Under Chapter 7 bankruptcy, a credit card company can challenge your attempt to discharge your unpaid balance if they know that the balance came from paying a nondischargeable tax. Under Chapter 13, this plan can work, although recall from earlier than Chapter 13 bankruptcies require you to set up a payment plan. This means you’ll likely have to pay off a significant part of that credit card debt before any remaining balance gets discharged.
Conditions for Discharging IRS Tax Debts Through Bankruptcy
The exact eligibility requirement for discharging unpaid IRS taxes will vary based on your financial circumstances, as well as the type of bankruptcy you’ve filed. However, in addition to your debt consisting of federal income taxes, the following conditions are usually required before a discharge of your tax debts is possible:
- You didn’t engage in fraud or willful tax evasion when creating that tax debt.
- You filed a tax return for the debt you’re trying to discharge at least two years before filing for bankruptcy.
- Your tax debt stems from income taxes that originated from a return due at least three years ago.
- At least 240 days have passed since the IRS assessed the tax debt you want to be discharged, or the IRS hasn’t yet assessed the tax debt at all.
The 240-day requirement can sometimes get extended if the IRS agrees to pause its tax collection efforts or if you previously filed for bankruptcy.
How to File Bankruptcy for IRS Debt
Before filing for bankruptcy, you’ll first want to get a complete understanding of your financial situation. Having this information is necessary to figure out which bankruptcy type to file and complete the necessary bankruptcy forms. Most of the information you’ll need can be found in the following documents:
- Tax returns from the last four years.
- Proof of income for the last six months, such as pay stubs.
- Proof of debts and liabilities from the last six months, such as credit card statements and past-due invoices.
- Any financial statements from the last six months, such as those from bank and retirement accounts.
- Title and registration documents for any vehicles that you own.
- Any documents that can serve as proof of the value of any real estate property you own, such as a property appraisal.
Essentially, you want documents that can substantiate any income you generate, debts you owe, or property you own. After you have this information and paperwork, you can decide whether to file Chapter 7 or Chapter 13 bankruptcy. The overarching steps for filing either type are similar.
Your next step is to take the required credit counseling course. You’ll need to take this class with a Department of Justice-approved credit counseling agency. You must complete it within six months before you file for bankruptcy.
After you complete the credit counseling class (or while you’re taking it), you can start working on the required bankruptcy forms that make up the bankruptcy petition. This will take some time, as these aren’t the shortest or simplest forms to complete, and there are more than 20 of them you’ll need to fill out.
It’s possible to complete these forms yourself with the help of the Internet. However, if you aren’t sure at any point or find a form or question confusing, it’s a good idea to contact an attorney. You’ll want to make sure the information you write on the forms or include with them is accurate and that you’re 100% honest with the information you provide.
If you are not, a best-case scenario is a delay in your bankruptcy proceeding or having to amend your bankruptcy petition. The worst-case scenario is having your bankruptcy petition dismissed with prejudice. This means you’ll be barred from filing bankruptcy again for a period of time or be unable to discharge a debt included in the bankruptcy petition that the bankruptcy court dismissed with prejudice.
Once your forms are properly completed, you’ll need to obtain the filing fee, which will be $313 for Chapter 13 bankruptcy and $338 for Chapter 7 bankruptcy. If you’re filing Chapter 7 bankruptcy and can’t afford to pay the filing fee all at once, you may be eligible to pay it over time or obtain a fee waiver.
You’ll usually file your bankruptcy petition at the federal courthouse that’s located in the federal district where you live. In almost all cases, this federal courthouse will be the location of the bankruptcy court that has jurisdiction over your case. When filing your petition, make sure you have enough copies as required by your bankruptcy court. Regardless of whether you file for Chapter 13 or Chapter 7 bankruptcy, you’ll get the benefit of the automatic stay as soon as you file bankruptcy.
What Happens After Filing Bankruptcy for Unpaid Taxes?
The single most important thing that happens right after you file for bankruptcy is that the court will temporarily stop creditors, including the IRS, from trying to collect their debts from you. This is called the automatic stay.
The automatic stay is an invaluable tool for buying time and stopping creditors from repossessing or seizing property from you. For example, if the IRS was about to use a tax levy to take money from your bank account, the automatic stay would stop them, at least temporarily.
This pause on collection action is in effect for as long as your bankruptcy case lasts, which is usually until the discharge of any debts (in either a Chapter 7 or 13) or the bankruptcy court dismisses your case. In some situations, the automatic stay can last a shorter amount of time (or not be available at all), such as if you filed for bankruptcy one or more times within the last year.
After you file your bankruptcy petition, you’ll send financial documents to your bankruptcy trustee. They should mail you a letter identifying the documents they want you to send them.
How Does Filing Bankruptcy Affect My Future Taxes?
Filing bankruptcy will hurt your credit history, including your credit score. How far your credit score drops depends on how high it was before filing. The higher it was before filing, the further it would fall.
As for your taxes, as long as you file and pay any required returns and tax payments in a timely manner, you should see no changes in your IRS tax obligations. Just remember that any taxes you incur after you file your bankruptcy petition aren’t affected by any discharge by the bankruptcy court.
While the IRS isn’t more likely to audit you just because you filed for bankruptcy, certain factors may mean you are at a higher or lower risk of getting audited. Your risk could be higher because whatever financial struggles you were dealing with that led to bankruptcy might create audit red flags for the IRS. Alternatively, if you’ve filed for bankruptcy, it tells the IRS that you’re having financial struggles, which means the IRS might be less likely to audit you, knowing there’s a good chance that any unpaid taxes they find will go unpaid.
Outside of bankruptcy, the IRS considers forgiven debts as taxable income. Fortunately, there’s a special exception for debts forgiven through bankruptcy. Therefore, any IRS tax debts discharged through bankruptcy won’t be considered taxable income.
Alternatives to Filing Bankruptcy on Unpaid Tax Debt
Because of its financial and emotional costs, as well as the legal limitations on discharging certain tax debts, bankruptcy should be a last resort for dealing with tax bills you can’t afford. Luckily, several alternatives are available to resolve your tax debt, including an Offer in Compromise, Currently Not Collectible, and payment plans. These can provide you with additional time to pay your taxes and even reduce the tax balance you have to pay.
Thinking About Using Bankruptcy to Eliminate Your Tax Debt?
If you’re considering bankruptcy as a solution for your IRS debt, you should strongly consider getting professional advice from a bankruptcy or tax attorney. The bankruptcy process is complicated, with many steps where things could go wrong. It can also be difficult to decide which bankruptcy filing is best for you. Then, there’s the fact that you could resolve your tax issues without having to file a bankruptcy petition. To learn more about what you can do, contact Wiggam Law. You can reach us using our online consultation request form or by calling (404) 233-9800.