When facing overwhelming tax debt, many individuals and business owners wonder if filing for bankruptcy could offer relief. Although bankruptcy can discharge certain types of debt, including some tax obligations, the rules are complex, and not all tax debts are eligible. Understanding how bankruptcy works – and the specific conditions under which tax debt can be discharged – is key to making an informed decision.
Understanding Bankruptcy: Chapter 7, 11, and 13
Before diving into how bankruptcy may help you with tax debt, it’s important to understand the different types of bankruptcy filings available to individuals and businesses.
Chapter 7 Bankruptcy – Liquidation
Chapter 7 is the most common form of bankruptcy for individuals. It involves the liquidation of non-exempt assets to pay off creditors. Once assets are liquidated, most unsecured debts, including credit card balances and medical bills, are wiped out.
Tax Debt and Chapter 7
Certain tax debts can be discharged under Chapter 7, but only if they meet strict criteria:
- The tax debt must be income tax debt (not payroll taxes or fraud penalties)
- The tax return must have been due at least three years before the bankruptcy filing
- You must have filed a legitimate tax return for the debt at least two years prior
- The tax assessment must have been made by the IRS at least 240 days before filing
- There must be no evidence of tax fraud or willful evasion
If all these conditions are met, the IRS tax debt may be eligible for discharge.
Chapter 13 Bankruptcy – Wage Earner’s Plan
Chapter 13 is designed for individuals with a regular income who can pay back some of their debts over time. This type of bankruptcy sets up a 3- to 5-year repayment plan, after which remaining eligible debts may be discharged.
Tax Debt and Chapter 13
Although Chapter 13 won’t automatically eliminate your tax debt, it allows you to:
- Pay priority tax debts (like recent income taxes) in full over the life of the plan
- Possibly discharge older, non-priority tax debts that meet the same conditions required in Chapter 7
- Stop penalties and interest from accruing on dischargeable debts during the repayment period
Chapter 13 also protects your assets from liquidation and gives you time to catch up on missed payments.
Chapter 11 Bankruptcy – Reorganization
In general, Chapter 11 is used by businesses but is also available to individuals with very high debt levels. This form of bankruptcy allows for the reorganization of debts while the debtor remains in control of operations.
Tax Debt and Chapter 11
Chapter 11 can help businesses and high-debt individuals restructure tax debt along with other obligations. Tax debts may be:
- Paid over time under a court-approved plan
- Potentially discharged if they meet eligibility criteria similar to those in Chapter 7
Because of the complexity and cost of Chapter 11, it’s typically used in larger or more complicated financial situations.
Which Tax Debts Can Be Discharged?
Here’s a quick recap of the conditions that make IRS tax debt dischargeable in bankruptcy:
- It must be federal or state income tax debt
- The return was due at least 3 years ago
- You filed the return at least 2 years before filing for bankruptcy
- The tax was assessed at least 240 days before the bankruptcy
- There is no fraud or intentional tax evasion involved
If your tax debt meets all these criteria, you may be able to discharge it through Chapter 7 or Chapter 13 bankruptcy.
Tax Debts That Cannot Be Erased
Certain tax debts are rarely dischargeable, including:
- Payroll taxes withheld from employees
- Trust fund recovery penalties
- Tax liens filed before bankruptcy (even if the underlying debt is discharged)
- Fraudulent returns or evasion penalties
Even if your tax debt is dischargeable, any liens the IRS has filed before your bankruptcy may survive and continue to encumber your property.
Alternatives to Bankruptcy for Tax Debt Relief
Bankruptcy isn’t the only option for resolving IRS debt. Here are a few alternatives that may help you reduce or eliminate your tax burden.
1. Offer in Compromise (OIC)
An Offer in Compromise allows you to settle your tax debt for less than you owe if you can prove that paying in full would cause significant financial hardship. Qualification depends on your income, expenses, assets, and ability to pay.
2. Installment Agreement
If you can’t pay your taxes in full, the IRS may allow you to pay your debt in manageable monthly payments over time. Depending on your financial situation, this can help you avoid more aggressive collection actions.
3. Currently Not Collectible (CNC) Status
If you’re experiencing serious financial hardship, the IRS may temporarily suspend collection efforts by placing your account in “Currently Not Collectible” status. This doesn’t erase the debt, but it provides breathing room.
4. Penalty Abatement
In some cases, you may qualify for the removal of certain penalties (penalty abatement) if you can show reasonable cause (e.g., illness, natural disaster, or other extenuating circumstances).
5. Innocent Spouse Relief
If your tax debt is the result of your spouse’s error or fraud, and you were unaware, you may be eligible for relief from joint tax liability.
Is Bankruptcy Right for You?
Bankruptcy can offer relief from tax debt, but it’s not a silver bullet. The rules are strict, and not all debts qualify for discharge. If your tax debt meets the eligibility criteria, Chapter 7 or Chapter 13 may help. Otherwise, alternatives like an Offer in Compromise or a payment plan could provide a more tailored solution.
Before making any decisions, consult with a qualified tax professional or bankruptcy attorney to evaluate your options. Resolving tax debt is possible – it’s just a matter of finding the right path for your situation.