A bankruptcy case can wipe out (discharge) older income tax debt that meets qualification guidelines. It can also give you a way to pay back recently assessed taxes at a payment amount lower than what the IRS would offer. In this article, you’ll learn more about how bankruptcy can help with your IRS debt.
How Bankruptcy Stops the IRS
When you file a bankruptcy case, an injunction (a type of court order) called the automatic stay goes into effect to stop creditors, including the IRS, from starting or continuing collection activity, like sending you letters, garnishing your wages or your bank account, or filing liens against your property.
The stay continues during the bankruptcy case. It can be lifted only by the bankruptcy court after a request by the creditor (and only for a good reason).
Once the bankruptcy case is over, the IRS will be free to resume collection activity unless the tax debt has been wiped out (discharged) or paid in full.
Keep in mind that the automatic stay will go into effect the first time that you file for bankruptcy. However, that’s not always the case for subsequent filings. You could lose the stay if you’ve had repeated bankruptcy filings.
Which Tax Debts Get Discharged?
Debtors can discharge some tax debt in bankruptcy, but not all. Taxes must meet the following criteria before being forgiven:
- The taxes are on wage-related income or gross receipts (business income).
- The income taxes were due at least three years (including valid extensions) before you filed the bankruptcy.
- You filed your tax return at least two years before you filed the bankruptcy case. If you did not file a return, if you filed the return late, or if the IRS filed a substitute return for you, some bankruptcy courts have held that those taxes will never qualify for a discharge.
- IRS tax assessment—the process of entering the tax on the books as a tax liability—occurred at least 240 days before filing for bankruptcy. This period could be lengthened if you had pending an offer in compromise or if you filed a prior bankruptcy case.
- You didn’t commit fraud or willfully try to evade paying your taxes for the tax year in question.
If you meet all of these factors, the chances are that your tax debt will be dischargeable. If not, your tax obligation won't go away in a bankruptcy case.
What Happens to a Nondischargeable Tax Debt?
Income tax debts are treated differently depending on whether you file a Chapter 7 bankruptcy or a Chapter 13 case.
- Chapter 7 bankruptcy. Except for the automatic stay, bankruptcy cases don’t have much effect on tax debts that can’t be discharged. Once the bankruptcy court issues the discharge, the court clerk will close the bankruptcy case. (A case might remain open if the court-appointed trustee has to gather and sell the debtor’s nonexempt property.) If the bankruptcy case doesn’t discharge the IRS tax debt, the IRS will be free to resume collection actions.
- Chapter 13 bankruptcy. If you have nondischargeable IRS debt, you can use a Chapter 13 payment plan to manage it. You'll propose a plan to pay your IRS debt (along with your other debts) over a three- to five-year period. You’ll still get the benefit of discharging your older unsecured IRS debt, and your nondischargeable debt will get paid in full.
IRS Tax Liens: A Game Changer
If the IRS has filed a tax lien, your case gets a little more complicated. A tax lien will turn the tax debt into a secured obligation that must be repaid regardless of the chapter you file—even if the tax is old and would have otherwise been dischargeable.