When outstanding tax debt becomes overwhelming, you should weigh all of your options. There are two main types of bankruptcy you can use to discharge tax debt, but it’s important to work with legal and financial professionals to determine the best course of action for your specific situation.
What is bankruptcy?
Bankruptcy is a legal process that helps you deal with debt you cannot pay off, but it should be considered an option of last-resort since it comes with significant trade-offs and is only available if you meet certain requirements.
Even if you qualify, it’s not an easy fix. Rather, you’re in for a long ordeal that will, hopefully, allow you to satisfy your debts either by liquidating assets or enrolling in a payment plan with creditors.
There are two primary types of bankruptcy: Chapter 7 and Chapter 13.
Chapter 7 bankruptcy
In Chapter 7 bankruptcy, a trustee takes control of your assets and tries to sell them to make your creditors whole. You may be allowed to retain some of your assets.
Typically, whatever debt remains would be forgiven. In order to qualify for this type of protection, you need to pass a means test proving that you are unable to pay back loans through your income.
“Chapter 7, also known as a ‘straight bankruptcy,’ allows you to discharge certain types of unsecured debt, such as credit card debt and medical bills,” said Daniel Colston, CFP and chief executive of Upward Financial Planning in Roanoke, Va.
Chapter 13 bankruptcy
Chapter 13, provides another option. In this form of bankruptcy protection, you craft a plan to pay back your creditors over a short period.
“Known as a ‘wage earner’s plan,’ it is a reorganization bankruptcy that allows individuals with regular income to pay off debt over a period of three-to-five years,” said Colston. “This can include certain types of taxes, as well as other unsecured debts.”
If you complete a budgeting course and make timely payments to your creditors for the whole time period, the rest of your debt will be forgiven and you may be allowed to keep some assets that may otherwise have been liquidated if you had used Chapter 7.
What is tax debt?
Tax debt is an amount of money that you owe to a government. You can owe federal tax debt to the Internal Revenue Service (IRS), state tax debt to your state’s department of revenue and county or municipal tax debt to your local government.
Your tax debt could be from not paying income tax, property tax or payroll tax, among other obligations. Though how much you owe depends on several factors including how much you may have already paid, your income and your filing status (such as single or married, filing jointly). It can also include penalties and interest on the original unpaid amount.
How to discharge tax debt
Individual taxpayers may be able to discharge tax debt via Chapter 7 or Chapter 13 bankruptcy, but there are several qualifiers that must be met.
The debt is from unpaid income tax
Tax debt that can be discharged via bankruptcy include federal and state income tax debt. Other types of taxes from your federal, state and local governments likely can’t be discharged via bankruptcy, depending on your specific circumstances and the presiding laws in your area.
Be overdue for dates on payment, filing, assessment
For tax debt to be eligible for discharge, your taxes must have been due at least three years ago.
On top of that, “the returns must have been filed at least two years ago, and the taxes have been assessed more than 240 days ago,” said Ashley Morgan, bankruptcy attorney and founder of Ashley F. Morgan Law in Herndon, Va.
Have tax debt due to lack of funds, not avoidance
You can’t clear tax debt simply because you don’t want to pay it. Authorities must find that there was no willful avoidance of the original tax and no fraudulent tax filing.
What is a tax lien and can you discharge that too?
A tax lien is a legal and financial claim on your property.
“Usually a tax lien is thought of as something that is attached to someone’s house that the IRS files once you are significantly behind,” said Morgan.
However, there’s more to it. Not paying your federal taxes on time automatically triggers an IRS collection process and may initiate a Notice of Federal Tax Lien.
The lien can attach to everything you currently have and anything you purchase during the time that it’s active. It can hurt your chances of getting approved for credit while it’s active because it can include retirement assets, cars and jewelry.
“The IRS rarely enforces against these other items, but it does happen,” Morgan said.
Tax liens can complicate your bankruptcy filing.
“[I]t is possible to get tax liens discharged in Chapter 7 bankruptcy, but the lien will remain on the property and will have to be paid if the property is sold,” Colston said.
If you have a tax lien and want to sell an asset, such as a house, you must first satisfy the lien. You could use personal funds or agree to pay it off with cash gained from selling the asset. Here’s how to apply for a certificate of discharge from a federal tax lien. It’s released within 30 days of paying your debt in full.
Common types of bankruptcy to help with tax debt
Chapter 7 bankruptcy
You must meet income requirements in order to qualify for Chapter 7 bankruptcy. Instead of making payments on outstanding debts, your assets are liquidated. The proceeds are then distributed to your creditors to settle your debt. You can apply to exempt some property, such as your car so you can still drive to work.
“If the tax debt is dischargeable and there are no issues with tax liens and assets, then a debtor could get rid of some or all of their tax debt,” said Morgan.
Chapter 13 bankruptcy
Chapter 13 bankruptcy may be best if you’re able to make payments through income or assets.
“During a Chapter 13, a debtor may pay some or all of their tax debt back,” said Morgan. “This is useful for individuals who have various debts and need one plan to deal with them all.”
The payments typically last three-to-five years and are split up among the person’s creditors, which can include the government.
Alternatives to tackling tax debt without filing for bankruptcy
There are alternatives to paying overdue taxes without having to file for bankruptcy.
Installment agreement: An installment agreement is a payment plan that lets you spread out your overdue taxes over an extended period of time. There are two options for individuals:
- Short-term payment plan: Pay your outstanding balance in full within 180 days and avoid any set-up fees. Penalties and interest continue to accrue until the balance is paid. The total owed amount must be less than $100,000.
- Long-term payment plan: Make monthly payments until your balance is repaid. Set-up fees apply and penalties and interest continue to accrue. The maximum owed amount must be $50,000 or less.
Offer in compromise: You may qualify to settle your tax bill for less than what you owe; however, it’s a complex process to get approved.
“This is because you are asking to settle your liabilities for a much lower number than you owe,” said Morgan. “This analysis often uses strict expenses in the analysis and takes a hard look at all your assets, including retirement accounts and equity in your property.”
Temporary delay: Another option is to apply for a temporary delay in the collection process if you cannot afford the payments. You’ll need to apply with the IRS to show proof of your financial status. Note that penalty and interest still accrue, even if you’re approved for a delay.
Frequently asked questions
It is possible to have IRS debt discharged during chapter bankruIt is possible to have IRS debt discharged during chapter bankruptcy, but eligibility is determined on a case-by-case basis.ptcy, but eligibility is determined on a case-by-case basis.
No. While many outstanding debts are discharged after the bankruptcy process is complete, some types of debt are not eligible. These include things like alimony, child support, federal student loans, and court-ordered personal injury debts.
Property taxes are not considered dischargeable during bankruptcy. But Chapter 13 bankruptcy can pause any debt collection, including a foreclosure due to outstanding property taxes. Additionally, your property taxes could be prioritized as part of your payment plan.
Businesses that have not paid sales tax on their sold goods or services may have outstanding sales tax owed to the government. Unfortunately, this type of debt is not cleared with bankruptcy.
State income tax debt is also considered alongside federal tax debt when going through bankruptcy.
