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Discharging Taxes in Bankruptcy

It’s common knowledge that many people who are in debt use a Chapter 13 bankruptcy to buy time to pay off their tax debts.

There are tax debts that can be discharged in a Chapter 7 bankruptcy but there are strict requirements that you must meet, and you essentially must hope that the Internal Revenue Service was sloppy with your file somewhere.

A chapter 7 bankruptcy is normally used for people who have unsecured debts.

Unsecured debts usually include medical bills and credit card debts. Unsecured means no collateral was provided to obtain the loan.

Secured debts are debts where the you agree at the time of the loan that if you fail to pay the loan, the creditor can seize the item you bought with the loan.

A common example of a secured debt is when you obtain a loan to buy a house.

You agree that if you don’t pay the mortgage loan, that the creditor can repossess your home.

Another common example is when you use a loan to buy a car.

If you fail to pay the car loan, the creditor can repossess your car.

Requirements for discharging a tax debt in bankruptcy

If you owe taxes, you can discharge the tax debt only if all of the following conditions are met:

  • The debt is from federal income tax. State income taxes do need to be paid.
  • The taxes are for income. If you own payroll taxes or owe taxes due to fraud, those taxes must be paid. They can’t be discharged in the bankruptcy. This means if you filed a fraudulent return or willfully tried to evade paying taxes, you will have to pay the income tax – even in bankruptcy. The same holds true if you filed the returns under a false Social Security number.
  • The federal income tax debt must be at least three years old. This means you can’t use the bankruptcy laws to avoid paying taxes on your most recent tax years. The three-year time frame dates back to when the taxes were originally due.
  • You must have filed a tax return for the years that you are seeking to discharge the debt. This means you can’t refuse to file a return and then hope the IRS doesn’t do anything. For the purposes of filing a tax return, the bankruptcy court will look to see that you filed the return at least two years before the filing date of your bankruptcy. Generally, if you filed for a tax extension, which is usually six months, and then filed your return within the extension period, that will be considered a timely return. Some bankruptcy courts may even consider a return timely filed beyond the extension period – provided it was filed at least two years before the bankruptcy filing date.
  • If you meet the 240-day rule. This means that the Internal Revenue Services must have assessed the amount you owe at least 240 days (about eight months) before the date of the bankruptcy petition. Usually, the IRS files an assessment within a few months from the date you file your return. If you negotiated a settlement of your tax duty and the IRS suspended collection actions during the negotiation, the 240-day time frame may be even longer.

What happens if there is a federal tax lien?

The ability to discharge a tax lien also depends on whether there is a federal tax lien that has been recorded against you.

This means that even if your taxes are more than three years old, you filed your returns within the two-year time frame, and you also meet the 240-day threshold – you still can’t discharge your debts if the IRS recorded a tax lien on your property before the date you filed your petition.

What does this mean?

It essentially means that your home will become security for your debt. You will be able to discharge your personal obligation to pay the loan.

The IRS won’t be able to access your bank account or your wages.

The problem is that when you sell your home, the taxes will be paid from any sales proceeds before you will be entitled to any money.

If you don’t own a home, you just rent, then the federal tax lien essentially has little effect because there’s nothing to sell.

Using a Chapter 13 bankruptcy to pay your taxes

The more practical solution for many debtors who find that they can’t pay their federal income tax obligations is to file for a chapter 13 bankruptcy.

The Chapter 13 bankruptcy gives you time to pay off the arrears which is the amount you owe on your prior taxes.

You still must file timely tax returns and pay the amounts due for each year after you file your bankruptcy petition.

Chapter 13 can be used for federal income taxes and for state income taxes.

The good news is that there is no three-year time limit.

If you failed to pay $7,500 on your two tax returns for each of the past two years, you can pay out the total due, $15,000, by filing a Chapter 13 plan.

The plan requires that you pay the arrears (in this case $15,000) over a three to five-year time period.

During those three to five years, you must file and pay your new federal and state income taxes as they become due.

Extensions may be allowed.

It’s important to review your tax payment obligations with an experienced bankruptcy attorney.

If you don’t owe too much, you may also be able to enter into an installment plan with the IRS instead of declaring bankruptcy.

Your bankruptcy attorney will be able to properly advise you on your options.