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While it is true that most tax debt cannot be eliminated by filing for bankruptcy protection, under some circumstances outstanding tax liabilities can get discharged when you or your business become insolvent. It is worthwhile to understand when, how and to what extent a bankruptcy proceeding will result in the successful removal of your tax debt.
This article explores bankruptcy fundamentals in the context of tax liabilities and identifies the circumstances that support the discharge of tax debt via bankruptcy, including a discussion of the survivability of tax liens as well as alternatives to bankruptcy.
Bankruptcy in the Context of Tax Debt
Bankruptcy is a legal process whereby individuals or entities that cannot repay debts to creditors seek relief from some or all of their debts by court order. When you file for bankruptcy protection, a discharge from the court will relieve you from your obligations to pay certain creditors and, following a successful discharge, those creditors are precluded by law from attempting to collect the debt in any way.
In the context of bankruptcy, tax debt is treated differently than other kinds of debt. A past due tax liability is typically regarded as a “nondischargeable priority debt,” meaning that bankruptcy won’t eliminate the liability and also that repayment of this specific debt is given priority over other creditors’ claims. However, there are certain circumstances where tax debt will be considered a dischargeable debt that can be eliminated via bankruptcy.
Circumstances that Support the Discharge of Tax Debt in Bankruptcy
The circumstances that support the discharge of tax debt vary depending on whether you file for Chapter 7 Bankruptcy or Chapter 13 Bankruptcy.
Chapter 7 Bankruptcy is available to eligible Individuals or business entities and involves a complete liquidation plan where the debtor sells off all assets and submits the proceeds to creditors in order of priority or as determined by the bankruptcy plan. When there are insufficient assets to satisfy an outstanding obligation, the debt gets discharged and the creditor(s) will not receive payment from the debtor.
The circumstances that support the discharge of tax debt under Chapter 7 include:
- The tax debt must be associated with federal or state income tax debt. Other taxes such as payroll taxes or penalties based on fraud cannot be discharged in bankruptcy.
- The tax debt must be at least 3 years old. This means that the original tax return must have been due at least 3 years prior to the date of the bankruptcy filing.
- You must have filed a tax return for the debt that you seek to discharge at least 2 years before filing for bankruptcy and the tax return must have been submitted timely.
- You did not file a fraudulent tax return or willfully evade the obligation to pay your taxes.
- The IRS must have assessed the tax debt at least 240 days before you file the bankruptcy petition, or not at all. This time period may be extended if the IRS collection statute is tolled for any reason (e.g., previously submitted offer in compromise, prior bankruptcy action).
Chapter 13 Bankruptcy is available only to eligible individuals and involves a reorganization plan with partial liquidation of unsecured debts and retention of assets associated with secured debt.
In a Chapter 13 filing:
- Nondischargeable tax debts are paid off under a reorganization plan which typically requires repayment within 3-5 years.
- Any tax debts over 3 years old (dischargeable) may get discharged subject to a showing of insufficient disposable income on the part of the petitioner.
- Dischargeable taxes won’t accrue interest and penalties while the petitioner is paying them off subject to the bankruptcy plan.
- You can satisfy an IRS tax lien by paying what is owed per the plan.
- The IRS is required to abide by the plan if the taxpayer/petitioner includes all outstanding income tax obligations, stays filing compliant, and stays current on taxes that are due throughout bankruptcy proceedings and thereafter.
There are specific eligibility requirements for each kind of bankruptcy filing. Taxpayers are encouraged to consult with tax and bankruptcy counsel to determine possible resolution options with the relevant tax authority and to ascertain whether they are eligible to pursue protection under federal bankruptcy law.
Tax Liens & Bankruptcy
A tax lien differs from a tax debt in that the debt represents money that the taxpayer owes to the federal or state tax authority whereas the lien constitutes a legal judgment secured against the taxpayer’s property (e.g., bank accounts, personal possessions and real estate) to satisfy the tax liability.
While bankruptcy may discharge tax debt, it will not remove a prior recorded tax lien. For example, if your tax qualifies for discharge in bankruptcy, but the IRS recorded a tax lien on your property prior to the bankruptcy filing, the obligation to pay the IRS will get discharged thereby preventing the IRS from pursuing collection in the form of a bank levy or wage garnishment, however, the lien will remain on the property and cannot be transferred to the new owner until the debt underlying the tax lien is satisfied.
Do You Need a Tax Attorney?
A tax attorney can review your case and determine what options exist to resolve your outstanding tax liability, whether with the IRS directly or via a bankruptcy proceeding. You may be able to set up an affordable payment plan or not collectible status with the IRS or pursue a settlement via an offer in compromise, thereby obviating the need to file for bankruptcy.
A tax attorney can also obtain your account transcripts and advise you as to what tax debt might be dischargeable and determine if a tax lien has been filed. You may need to file missing tax returns in order to be eligible to file for bankruptcy, in which case a tax attorney can obtain your wage and income transcripts to help you get filing compliant.
The experienced tax attorneys at Segal, Cohen & Landis have helped clients with overwhelming tax liabilities avoid bankruptcy by providing the following services:
- Assistance with filing compliance and correction of Substitute for Return (SFR) balances
- Installment arrangement involving removal of federal tax lien
- Partial pay installment arrangement
- Not collectible status
- Offer in compromise
- IRS Appeals
We review all of the possible options with our clients so that they can make an informed decision about how to best handle the resolution of their tax debt. When warranted or requested, we will also refer them to bankruptcy counsel so that they can have a complimentary, preliminary conversation about their eligibility to file for bankruptcy and the implications thereof.
If you are interested in having a complimentary consultation with one of our partner attorneys regarding your tax matter, please feel free to contact us at 866-505-1872. We would be happy to advise you as to how we can resolve your case and how much it would cost.