In a NutshellIn some situations, bankruptcy can wipe out federal tax debt. In others, it can’t. The rules for bankruptcy and taxes are strict and complex, so it’s important to understand what you’re getting into before you try to discharge tax debt through bankruptcy.
This article was fact-checked by our editors and reviewed by CPA Janet Murphy, senior product specialist with Credit Karma.
Bankruptcy is supposed to help you get a fresh start when you have too much debt, but it will affect far more than just your credit scores.
There are different types of bankruptcy — called “chapters” — and the type of debt you have can influence the chapter you need to file, and how your bankruptcy case will progress. In some cases, the bankruptcy court may require you to sell your assets in order to pay part of your debt. Or, the court may make a payment arrangement for you to pay off creditors over several years before the remaining balance of your debt can be discharged.
If your debts include tax debt, you may be able to get it discharged, depending on the type of tax debt.
Because laws related to bankruptcy and taxes are both complicated, it’s important that you understand before you file for bankruptcy how it will affect past tax debt as well as future obligations to the IRS. It’s best to consult with a lawyer before making any decisions about bankruptcy (and you may even qualify for free legal aid). But this guide can help you learn a little more about how bankruptcy can affect your taxes during and after filing.
- What is bankruptcy?
- Can tax debt be discharged in bankruptcy?
- Do you have to file a tax return when going through bankruptcy?
- Some good news about bankruptcy
- What are some other solutions for tax debt?
What is bankruptcy?
Bankruptcy is a legal process that helps people and businesses that can’t pay their debts. But there are different types of bankruptcy that deal with debt in different ways. These different types of bankruptcy are named for the chapter of the bankruptcy code that sets the rules.
Most people and companies seeking debt relief will file one of three types of bankruptcy.
- Chapter 7: Chapter 7 is also called straight bankruptcy. When you file Chapter 7, most of your assets are sold (although you may be able to keep certain exempt assets such as a car or household furnishings) and the proceeds are used to pay creditors. The remaining balance of dischargeable debts may be forgiven — meaning you don’t have to pay it and creditors can no longer try to collect the debt. Eligibility for Chapter 7 is based on income. Yours must be below the state median or you’ll have to pass a means test showing you can’t pay your bills.
- Chapter 11: Businesses or individuals can file for Chapter 11 bankruptcy. The goal of this type of bankruptcy is to reorganize and reduce debt, rather than just discharge it. The advantage of Chapter 11 is that a business can continue to operate and individuals can retain certain assets (like a home) that they might have to sell under Chapter 7.
- Chapter 13: Chapter 13 allows individuals to repay their debts on a payment plan that lasts three to five years. No property needs to be sold, and any remaining dischargeable debt balance is forgiven at the end of the repayment period — provided you’ve complied with your payment agreements. But, to be eligible, you must have a steady income so you can make your debt payments.
The bankruptcy court charges fees for filing a bankruptcy petition, and how much you’ll pay depends on the type of bankruptcy you file.
No matter which type of bankruptcy you file, only certain debts are dischargeable, or forgivable.
You can discharge unsecured debt, which is debt without collateral such as credit card debt and personal loan debt. But student loan debt, child support debt, alimony, fines and certain other kinds of debt typically can’t be forgiven. And you can’t get rid of mortgage or car loan debt if you keep the home or vehicle.
Can tax debt be discharged in bankruptcy?
While some debts are almost never dischargeable, the rules for other types of debt — like tax debt — aren’t quite so clear cut.
“It’s pretty complicated stuff,” says Robertson B. Cohen, a bankruptcy attorney at Cohen & Cohen, P.C. in Denver.
First and foremost, neither taxes you willfully attempted to evade nor penalties for tax fraud are dischargeable in bankruptcy. And, even without fraud, income taxes are dischargeable only under limited circumstances.
“There are three elements that need to be satisfied for tax debt to be dischargeable,” Cohen says.
- Taxes can’t be discharged in bankruptcy until at least three years after they were due. For example, 2020 taxes are due in April of 2021, so can’t be discharged until April of 2024.
- You must have filed a tax return for the tax you owe — and you must have filed it at least two years before your bankruptcy in order to get it discharged. So if you didn’t file 2015 taxes until 2019, you’d have to wait until 2021 before the debt could be discharged. And if you never filed a return, it may be impossible to get the tax debt discharged.
- Taxes must have been assessed within 240 days before your bankruptcy filing. So, if you were audited and your taxes were reassessed after Tax Day, you’d need to wait until 240 days after the audit.
“To determine dischargeability, we order account transcripts from the IRS,” Cohen said. “Often we will wait to file so we can discharge the most tax debt possible.”
Unfortunately, even if your taxes are discharged, this doesn’t mean tax liens go away. The tax lien would remain on your property if the IRS recorded it before you filed for bankruptcy, which can make it impossible to sell the property until you pay the debt.Learn about federal tax liens and levies
Do you have to file a tax return when going through bankruptcy?
While you can sometimes deal with past tax debt through a bankruptcy filing, you won’t be protected from all past, current or future tax liability or obligations to the IRS.
- Chapter 13 filers are required to file returns for tax periods ending within four years of the bankruptcy filing before you have a meeting with creditors to work out your debt repayment plan.
- In Chapter 7 and Chapter 11, the bankruptcy estate that takes ownership of your assets is also required to file a separate tax return. The return must be filed by the trustee appointed to manage assets — but sometimes in Chapter 11, the bankruptcy filer acts as the trustee and thus must take on this obligation.
And, no matter what chapter of bankruptcy you file under, all tax returns due after you file must be submitted on time unless you file for an extension. Failing to file or request an extension can result in dismissal of your bankruptcy proceedings or conversion of your bankruptcy to a different type.
Some good news about bankruptcy
The IRS considers many types of canceled debt to be taxable income. For example, if you get a credit card issuer to agree to cancel $5,000 of your credit card debt, you might have to count that amount as taxable income when you file your federal income tax return.
However, debt canceled in Chapter 11 bankruptcy is not considered taxable income.
That means if you owed taxes and got them canceled as part of a bankruptcy proceeding, you will not have to report that amount — or any of your other debt forgiven by the bankruptcy — as taxable income on a future tax return. But you may have to file a form (Form 982) with the IRS to verify that the debt was discharged through bankruptcy and therefore isn’t taxable income.
What are some other solutions for tax debt?
If unpaid tax debt has you considering bankruptcy, you may want to explore other solutions first — especially in light of the complex rules for bankruptcy and taxes.
These alternatives could include entering into an installment agreement with the IRS, making a deal with the IRS to delay collection efforts, or entering into an offer in compromise. An offer in compromise is an agreement between you and the IRS that allows you to pay a reduced amount.
There are pros and cons to each of these approaches. For example, you’ll need to pay a user fee for an installment agreement and will owe fees, interest and possible penalties. And the IRS won’t always accept an offer in compromise.
Still, because these solutions address only your tax debt and don’t affect other areas of your finances as much as bankruptcy does, they could be worth considering.
Bankruptcy could sometimes help you deal with unpaid income tax debt, but only in certain circumstances. Because it’s complicated to understand the rules for bankruptcy and taxes, it’s a good idea to get legal advice from a bankruptcy lawyer when deciding if filing for bankruptcy could help you eliminate or reduce the back taxes you owe.
A senior product specialist with Credit Karma, Janet Murphy is a CPA with more than a decade in the tax industry. She’s worked as a tax analyst, tax product development manager and tax accountant. She has accounting degrees and certifications from Clemson University and the U.S. Career Institute. You can find her on LinkedIn.