Federal Tax Debt and Bankruptcy: Navigating the Legal Landscape for Financial Relief


Bankruptcy Basics

Federal courts, in their exclusive jurisdiction over bankruptcy cases, give people and businesses a fresh start when they can no longer pay their debts. There are several chapters of bankruptcy under the United States Bankruptcy Code, but the most common ones for individuals and businesses are:

Chapter 7: Involves liquidation, where non-exempt assets are sold to pay off creditors. Individuals or businesses with significant unsecured debts may opt for Chapter 7.

Chapter 11: Primarily for businesses, it allows for reorganization and continuation of operations while developing a plan to repay creditors. It’s more complex and costly, often used by larger businesses.

Chapter 13: Geared towards individuals with a regular income, it involves a repayment plan to settle debts over a specified period, usually three to five years.

A bankruptcy case normally begins by the debtor filing a petition with the bankruptcy court. A petition may be filed by an individual, by spouses together, or by a corporation or other entity. The debtor is also required to file statements listing assets, income, liabilities, and the names and addresses of all creditors and how much they are owed. The filing of the petition automatically prevents, or "stays," debt collection actions against the debtor and the debtor's property. As long as the stay remains in effect, creditors cannot bring or continue lawsuits, make wage garnishments or other collection efforts including making telephone calls demanding payment.

Creditors receive notice from the clerk of court that the debtor has filed a bankruptcy petition. Some bankruptcy cases are filed to allow a debtor to reorganize and establish a plan to repay creditors, while other cases involve liquidation of the debtor's property.

Tax Debt and Bankruptcy

Tax debts are treated differently than other kinds of debt when you file for bankruptcy. There are situations when filing for bankruptcy can save you some money tax-wise, but in many cases you’re still on the hook. That means that even if you file for bankruptcy, you’ll still be responsible for paying any outstanding tax liability. However, there are some exceptions. If you can prove that your tax debt is the result of fraud or mistake, you may be able to have it discharged. Additionally, if you can show that paying your taxes would create an undue hardship, you may also be able to have your tax debt discharged.

It’s also important to note the difference between eligible debts for Chapter 7 vs. Chapter 13 bankruptcy. Income tax (with some restrictions) is the only kind of tax debt that can be discharged in a Chapter 7 bankruptcy filing. In Chapter 13 bankruptcy, most tax debt is reorganized through a Chapter 13 repayment plan, which can last three to five years. Certain tax debts can be discharged in Chapter 13, however dischargeable tax debt in Chapter 13 is not as common as Chapter 7.

Managing Tax Debt With Chapter 7 Bankruptcy

Chapter 7 bankruptcy can be the quicker, less complicated way to clear debt. Your tax debt can be discharged under Chapter 7 if:

  • It’s income tax;
  • The debt is at least three years old;
  • You did nothing fraudulent to evade paying your taxes;
  • You filed a tax return for the debt you hope to discharge at least two years before filing for bankruptcy; and
  • The IRS must have assessed the tax debt at least 240 days before your filing.

Managing Tax Debt with Chapter 13 Bankruptcy

Chapter 13 bankruptcy is a reorganization of debt that must be repaid over a 3-5 year period. Not as quickly resolved as Chapter 7, it can be the smarter option in dealing with tax debt under certain situations. Certain tax debt can be discharged under Chapter 13, with the remaining balance paid over a 3-5 year period. Your tax debt can be managed under Chapter 13 bankruptcy if:

  • You are a wage earner, self-employed, or sole proprietor (one-person businesses); and
  • The tax debt is older than three years.

Whatever combination of bad luck and bad decisions steered you to the financial brink, bankruptcy can be a complicated and devastating decision that requires a full accounting of debt, assets – and tax obligations – that isn’t easily managed without professional help. The best option is usually to work with a tax attorney to resolve your situation. As such, contact the tax attorneys at The Wilson Firm to handle your tax debts, whether you are considering filing bankruptcy, or if you have already started the process.