Does bankruptcy clear tax debt? It depends
If you’re reading this, chances are you’re being hounded by the Internal Revenue Service (IRS)—and may even be contemplating bankruptcy.
The big question is: Does bankruptcy clear tax debt the way it does other debts? Unfortunately, the answer isn't a straightforward "yes" or "no."
Read on to learn about different types of bankruptcies and how they can affect your tax liabilities.
What bankruptcy and taxes have in common
When it comes to taxes, the IRS is the almighty entity that ensures everyone pays what they owe to keep the country running smoothly.
But life can be unpredictable, and sometimes circumstances can lead us down a path that causes us to struggle to meet our tax obligations. The reasons could be financial hardship, unforeseen emergencies, or a series of unfortunate events that land you in a tough spot.
That’s when bankruptcy enters the scene, like a knight in shining armor (or maybe not).
Bankruptcy is a legal process that allows individuals and businesses to get a fresh start by eliminating or restructuring debts. It comes in different flavors, but the two most common types are Chapter 7 and Chapter 13 bankruptcy.
Chapter 7 bankruptcy: A clean slate?
Let's start with Chapter 7 bankruptcy, often dubbed "liquidation bankruptcy." This type of bankruptcy allows individuals to get rid of most of their unsecured debts, like credit card debt and medical bills.
When it comes to tax debt, however, it gets a bit more complicated.
First, the good news: You may be able to discharge (a fancy term for wiping out) some income tax debts in a Chapter 7 bankruptcy, but not all of them. The tax debt must meet specific criteria to be eligible for discharge:
- The Three-Year Rule: The tax debt must be associated with a tax return you filed at least three years before bankruptcy. Late filers, beware!
- The Two-Year Rule: The IRS must have assessed the tax at least two years before filing for bankruptcy. In simpler terms, the IRS must have done its calculations and told you how much you owe at least two years ago.
- The 240-Day Rule: The tax debt must have been assessed by the IRS within 240 days before you filed for bankruptcy. Extensions and delays in assessments can complicate matters.
- No Fraud or Evasion: You cannot have engaged in any fraudulent or willful tax evasion activities. Being sneaky with your taxes won't help you here.
- Income Taxes Only: Chapter 7 bankruptcy only applies to income taxes. Other tax types, like payroll taxes, cannot be discharged this way.
Meeting these criteria can offer you the chance to eliminate your income tax debt through Chapter 7 bankruptcy. But don't celebrate just yet. Not everything is as simple as it seems.
Chapter 13 bankruptcy: A repayment plan
Chapter 13 bankruptcy is often called "reorganization bankruptcy."
Unlike Chapter 7, where debts can be wiped out, Chapter 13 sets you up with a repayment plan and allows individuals with a regular income to create a three-to-five-year plan to pay off their debts, including tax debt, in affordable installments.
So, if you don't qualify for Chapter 7, or you simply want to keep your assets while paying off your debts, Chapter 13 could be the way to go. But don’t overlook the devil in the details.
Why Chapter 13 might be your best bet
Filing for Chapter 13 bankruptcy can be a smart move for several reasons.
First, it puts a halt to collection actions, including IRS tax liens and levies. No more sleepless nights worrying about the IRS seizing your property or bank accounts. The automatic stay that comes with Chapter 13 can offer much-needed relief.
Second, by creating a repayment plan, you get the chance to gradually get your finances back on track. The plan is tailored to your income and expenses, making it feasible for you to make manageable payments.
This way, you can keep your assets while gradually chipping away at your tax debt.
Considerations before filing for bankruptcy
Before you jump headfirst into bankruptcy proceedings, it's essential to consider some critical factors.
Bankruptcy can have far-reaching consequences, and it's not a decision to be taken lightly. Here are some key points to ponder:
- The impact on your credit: Bankruptcy will significantly impact your credit score, and it will stay on your credit report for years. This might make it challenging to get loans or credit in the future.
- Tax liens: Bankruptcy might not remove tax liens that have already been recorded against your property. These liens will remain, and you'll need to address them separately.
- Non-dischargeable tax debts: Some tax debts, like those from fraudulent tax returns or payroll taxes, cannot be discharged in bankruptcy. You'll still be on the hook for these even after bankruptcy.
- Rebuilding your finances: Bankruptcy might provide relief, but it won't solve all your financial woes. You'll need a plan to rebuild your finances and prevent future debt.
- Alternative solutions: Explore alternative options before deciding on bankruptcy. You may be eligible for an offer in compromise or an installment agreement with the IRS, which could provide relief without the need for bankruptcy.
Tying it all together
The relationship between bankruptcy and tax debt is complex and depends on various factors, such as the type of bankruptcy, the age of the tax debt, and whether it meets specific criteria for discharge.
While bankruptcy can offer relief and a fresh start, it's important to weigh the potential consequences and explore alternative solutions before making a decision.
In the end, the best course of action depends on your unique financial situation. Whether you pursue bankruptcy or explore other avenues, seeking professional advice from a bankruptcy attorney or tax specialist is highly recommended.
A professional can guide you through the process, help you make informed decisions, and ensure that you take the best steps to regain control of your finances.