If you’ve heard commercials offering the hope of eliminating tax debts in bankruptcy, be cautious. It's not as simple as it sounds. Most tax debts can't be wiped out in bankruptcy—you'll continue to owe them at the end of a Chapter 7 bankruptcy case or have to repay them in full in a Chapter 13 bankruptcy repayment plan. In this article, learn:
You’ll also learn the pros and cons of filing tax returns before or after bankruptcy.
If you need to discharge tax debts, Chapter 7 bankruptcy will be the better option—but only if the tax debt qualifies for discharge (not all do) and you’re eligible for Chapter 7 bankruptcy. All of these conditions must be met before you can discharge (wipe out) federal income taxes in Chapter 7 bankruptcy:
Some jurisdictions have additional requirements, too. For instance, in the ninth district, you must file your tax return in a timely fashion. Filing late precludes a discharge automatically. Also, in Chapter 7, if you paid off nondischargeable tax debt using a credit card, the credit card balance will be a nondischargeable debt, too.
If your taxes qualify for discharge in a Chapter 7 bankruptcy case, your victory may be bittersweet. Why? Bankruptcy won’t wipe out prior recorded tax liens. Chapter 7 bankruptcy will wipe out your personal obligation to pay the qualifying tax and prevent the IRS from going after your bank account or wages. But if the IRS recorded a tax lien on your property before the bankruptcy filing, the lien will remain on the property. You’ll have to pay off the tax lien before selling and transferring the property’s title to a new owner.
Filing your tax return might not be as burdensome once you realize that using Chapter 13 bankruptcy to manage your tax debt can be a smart move. Here’s why:
Bear in mind that any nondischargeable tax that won’t go away in bankruptcy (generally, those incurred during the last three tax years) must be paid in full during the three- to five-year Chapter 13 plan. When it’s over, you’ll be caught up on taxes and most or all of your other debts.
Unlike Chapter 7, in Chapter 13, you can discharge a credit card balance incurred due to paying off a nondischargeable tax debt. Learn more about tax debts in Chapter 13.
You won’t gain any real advantage by waiting to file your income tax return until after you file a bankruptcy case. But, there are many reasons you’ll want to be current when filing your Chapter 7 or Chapter 13 matter.
When you file for Chapter 7 bankruptcy, the trustee assigned to oversee your case will ask for your most recently filed tax return. That doesn’t necessarily have to be the tax return for the last tax year, but if it isn’t the most recent return, the trustee will ask for a written explanation.
The trustee will compare the income you report on your return to the amount listed in your bankruptcy paperwork. If you show that you’re due a refund, the trustee will also want to check that you have the right to protect (exempt) it and that you’ve claimed the proper exemption amount. If not, you’d be required to turn the refund over to the trustee, who would, in turn, distribute it to your creditors.
Many people plan to use the return for necessary items—such as living expenses—before filing a bankruptcy case. If you choose this approach, it’s a good idea to keep records of your expenditures.
You must be up to date on your tax returns before you file a Chapter 13 case, but the rules allow you a little wiggle room. You’ll provide copies of the returns for the previous four tax years to the Chapter 13 trustee before the 341 meeting of creditors (the hearing that all filers must attend). If you’re not required to file a return, your trustee might ask for a letter, an affidavit, or a certification explaining why. Sometimes local courts will impose additional rules for documents in their districts.
If you owe the IRS a return but don’t file it before your 341 meeting of creditors, things can happen to derail your case.
Find out more about debts you can eliminate in bankruptcy in The New Bankruptcy: Will It Work for You? by Cara O’Neill (Nolo).