Bankruptcy can be a great tool when it comes to managing past income tax debt. But it doesn’t help in all situations. The age of the tax and the status of your return will determine whether you can eliminate (discharge) federal income taxes by filing a Chapter 7 or a Chapter 13 bankruptcy case.
Not all federal income taxes get wiped out in bankruptcy. You’ll have to analyze your particular situation using a multi-step process (and it’s a good idea to verify your assessment by calling up the IRS’s bankruptcy department).
Here’s what you’ll need to consider.
The only type of IRS tax that you can wipe out is an individual’s income tax. Even though the IRS collects taxes on corporate income, gift and estate taxes, excise taxes on sales, and employee withholdings (income, Social Security, and Medicare taxes), it’s only your income tax that’s potentially dischargeable. (If the debt isn't dischargeable, consider using Chapter 13 bankruptcy to manage repayment.)
To discharge taxes for any given year, you have to come into the process with clean hands. The return cannot be fraudulent or frivolous, and you cannot have been found guilty of evading taxes for that year. If the IRS increases the amount that you owe based on an error on your return, your taxes might not get wiped out.
Your tax must be old. Specifically, it must have been due (with all extensions) at least three years before your bankruptcy filing date.
Example: Suppose that you owe taxes for the 2012 and 2015 tax years. The 2012 return was due April 15, 2013, but you requested an extension that expired on October 15, 2013. If you file a bankruptcy case on December 1, 2016, you'll have met the three-year rule for your 2012 taxes. By contrast, you won’t be able to discharge your income taxes for 2015. That return was due April 15, 2016, so the taxes won’t be dischargeable until after April 15, 2019 (assuming that you meet all other requirements).
Dischargeability rules require you to file your return at least two years before filing your bankruptcy case. A substitute return filed by the IRS for you most likely won’t count. Most bankruptcy courts find that a substitute return doesn’t meet the two-year rule.
If you file a return to replace the IRS substitute return, some courts will allow you to discharge the taxes from that return—but you’ll still have to wait two years before filing for bankruptcy. Other courts take a more hardline view and conclude that once the IRS files a substitute return the tax for that year can never be discharged. Also, some courts don’t allow for a discharge if you filed even a day late. You’ll want to talk to a local attorney about the chances of discharging your tax debt.
The IRS must have assessed the tax at least 240 days before the bankruptcy filing. Assessment occurs when the IRS records your liability for the tax on its books. For most, that will be the date on which you file your return. However, the IRS can assess additional taxes later, often after an audit. Taxes assessed less than 240 days before you file won’t get discharged.
If the underlying tax gets discharged, the interest will get wiped out, as well. A penalty will be included too unless it was intended to reimburse the government for money lost because of your failure to pay taxes.
The IRS has ways to increase the chance of getting paid. If you owe $10,000 or more in income taxes, the IRS can file a notice of tax lien. Once done, the IRS tax debt becomes a secured debt, meaning that the IRS can seize your real estate and other property, sell it, and pay the taxes you owe.
If you have a tax lien, discharging your tax debt won’t be quite as straightforward. You’ll want to consult with a bankruptcy lawyer about your options.
In a Chapter 7 matter, the taxes meeting all requirements will get discharged approximately four to six months after the filing of the case. You’ll remain responsible for paying any taxes that aren’t discharged. Further, any nondischargeable taxes will remain nondischargeable, even if you file a later bankruptcy case.
Taxes that are subject to a lien will also get discharged, but the lien won’t necessarily be released. Even though the IRS cannot collect from you (such as with wage garnishment), as long as the lien is in effect, the IRS can seize and sell your property to pay your tax debt.
If you file for Chapter 13 bankruptcy, you’ll need to pay off what you owe over three to five years unless you can negotiate a different schedule with the IRS.
You can also use bankruptcy to help you with nondischargeable IRS taxes, such as estate, gift, excise, and trust fund (employee withholding) taxes. For instance, a Chapter 13 plan might offer better terms than an IRS installment plan.