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Does Bankruptcy Clear Tax Debt?

Does Bankruptcy Clear Tax Debt?

Filing for bankruptcy protection under federal law typically halts harassment from bill collectors and provides relief from various debts. However, tax debt is handled differently compared to other types of debt. 

Under bankruptcy laws, taxes are usually classified as “nondischargeable priority debt.” This classification means that bankruptcy cannot eliminate tax debt, and repayment of these taxes is prioritized over other creditors’ claims.

Despite the general rule, however, there are specific conditions under which tax debt can be considered “dischargeable debt” and eliminated through bankruptcy. With legal assistance from a proven and trusted bankruptcy law firm, it may be possible to achieve significant debt relief through bankruptcy.

Photo of Bankruptcy Document

Tax Debts That Can be Discharged Through Bankruptcy

Here’s a breakdown of the types of tax debts that may be dischargeable:

Income Taxes

Income tax debt can be discharged in bankruptcy if it meets the following criteria:

  • Three-Year Rule: The tax return was due at least three years before filing for bankruptcy. This includes any extensions.
  • Two-Year Rule: The tax return was filed at least two years before filing for bankruptcy.
  • 240-Day Rule: The tax assessment was made at least 240 days before filing for bankruptcy.
  • No Fraud or Evasion: The tax return must not be fraudulent and there should be no willful attempt to evade taxes.

Property Taxes

Property taxes can be discharged if they meet specific conditions. Secured property taxes, such as those secured by a lien on the property, are generally nondischargeable. However, if the taxes are over a year old, the personal liability for the taxes may be discharged, but the lien on the property remains.

Employment Taxes

Employment taxes, such as those withheld from employee paychecks (trust fund taxes), are typically nondischargeable. However, the employer’s portion of employment taxes can be discharged if the tax debt is more than three years old and meets the criteria similar to income taxes.

Excise Taxes

Excise taxes can be discharged if they meet the following conditions:

  • Three-Year Rule: The tax debt is at least three years old.
  • 240-Day Rule: The tax was assessed at least 240 days before filing for bankruptcy.

Other Tax Debts

While rare, other specific tax debts may be discharged under certain conditions:

Tax Penalties: Penalties related to dischargeable taxes can also be discharged. However, penalties on nondischargeable taxes remain nondischargeable.

Notable Considerations for Clearing Debts through Bankruptcy

IRS Tax Liens

Even if the underlying tax debt is discharged, a federal tax lien recorded before the bankruptcy filing remains on the property. This means the IRS can still enforce the lien against the property, but not against the individual personally.

New York State Tax Lien

Collectibility of Non-Dischargeable Tax Debt:

  • Tax debt is collectible for up to 20 years.
  • The 20-year period is renewed each time a payment is made.

Creation of Tax Lien:

  • Established through the filing of a New York State Tax Warrant.
  • Attaches to all personal property for 10 years, regardless of location.
  • Attaches to all real estate located in the county where it is filed.

Exemptions and Protections:

  • 10% limit on salary garnishments.
  • $50,000 homestead exemption for residences.
  • Protections for qualified pension plans, profit-sharing plans, IRAs, and most retirement plans.

Tax Refunds

Your tax refund on your past tax returns is considered an asset in your bankruptcy filing. You may be able to claim an exemption in Chapter 7 to retain all or part of it. This allows you to use the exempted portion of your tax refund as you see fit.

Bankruptcy Filing and Timing

The timing of the bankruptcy filing is vital if you wish to discharge tax debt. Filing bankruptcy too early may result in the federal tax debt being non-dischargeable if it fails to meet the required criteria. Filing for bankruptcy will not affect your future tax filings. 

Different Types of Bankruptcy and Their Impact on Tax Debt

Chapter 7 Bankruptcy

Chapter 7 bankruptcy, also known as “liquidation” bankruptcy, involves the sale of a debtor’s non-exempt assets to repay creditors. It is typically used by individuals with limited income who cannot repay their debts.

Impact on Tax Debt

Dischargeable Tax Debts: Certain income tax debts can be discharged if they meet specific criteria:

  • The tax return was due at least three years before filing.
  • The return was filed at least two years before filing.
  • The tax was assessed at least 240 days before filing.
  • No fraud or willful tax evasion was involved.

Nondischargeable Tax Debts: Taxes that do not meet the above criteria, such as recent income taxes, trust fund taxes (like payroll taxes withheld from employees), and tax penalties on non-dischargeable taxes, cannot be discharged.

Tax Liens: Pre-existing tax liens on property remain even after the underlying tax debt is discharged, allowing the IRS to seize the property.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy, known as a “wage earner’s plan,” allows individuals with regular income to create a repayment plan to pay off debts over three to five years. It’s designed for debtors who can pay back some portion of their debts.

Impact on Tax Debt

Repayment Plan: Debts, including tax debts, are reorganized into a repayment plan.

Priority Tax Debts: Priority tax debts (e.g., recent income taxes and trust fund taxes) must be paid in full through the repayment plan.

Dischargeable Tax Debts: Older income tax debts that meet discharge criteria can be discharged after the repayment plan is completed.

Tax Liens: Tax liens remain unless specifically addressed in the repayment plan, potentially impacting property even after discharge.

Chapter 11 Bankruptcy

Chapter 11 bankruptcy, often referred to as “reorganization” bankruptcy, is primarily used by businesses but can be utilized by individuals with significant debt and assets. It involves reorganizing debts while continuing operations.

Impact on Tax Debt

Debt Reorganization: Debts, including tax debts, are restructured to allow the debtor to pay them off while maintaining business operations.

Priority Tax Debts: As in Chapter 13, priority tax debts must be paid in full according to the reorganization plan.

Dischargeable Tax Debts: Certain tax debts meeting discharge criteria can be eliminated after completing the reorganization plan.

Flexibility: Chapter 11 provides more flexibility in restructuring debts compared to Chapter 13, potentially offering more options for dealing with tax debts.

Alternatives to Bankruptcy for Resolving Tax Debt

For individuals and businesses struggling with tax debt, bankruptcy is not the only option. There are several alternatives provided by the IRS to help manage and resolve tax liabilities.

Offer in Compromise

An Offer in Compromise (OIC) allows taxpayers to settle their tax debt for less than the full amount owed. It is an option when taxpayers cannot pay their full tax liability or if paying the full amount would create financial hardship.

Gavel with money on table

Eligibility

  • Doubt as to Collectibility: There is doubt that the IRS can collect the full amount owed within the statute of limitations for collection.
  • Doubt as to Liability: There is doubt that the assessed tax debt is correct.
  • Effective Tax Administration: Paying the full amount would cause economic hardship or would be unfair and inequitable.

Installment Agreements

An Installment Agreement allows taxpayers to pay their tax debt over time in monthly installments. It is suitable for those who cannot pay their tax debt in full but can manage smaller, regular payments. Types of Installment Agreements include:

Short-Term Payment Plan: For debts that can be paid within 180 days.

Long-Term Payment Plan: For debts that require more than 180 days to pay off.

Eligibility

  • For individuals owing $50,000 or less in combined tax, penalties, and interest.
  • For businesses owing $25,000 or less in combined tax, penalties, and interest.
  • Must be current with all tax filings.

Innocent Spouse Relief

Innocent Spouse Relief provides relief from tax liability for a spouse who filed a joint tax return and was unaware of errors or omissions made by the other spouse.

Eligibility

  • The tax understatement is solely attributable to the other spouse’s error or omission.
  • The requesting spouse did not know and had no reason to know of the understatement.
  • It would be unfair to hold the requesting spouse liable for the tax debt.

Choose an Experienced Bankruptcy Attorney to Minimize Your Tax Liabilities  

If you are struggling with overwhelming tax debt, the dedicated bankruptcy lawyers at Macco & Corey P.C. are here to help. With over six decades of combined experience in bankruptcy law, our team is uniquely positioned to guide you through the complexities of tax debt resolution. Whether through Chapter 7, Chapter 13, or Chapter 11 bankruptcy, we will prepare and pursue the most effective strategy to address your specific needs and maximize your financial relief. Reach out to Macco & Corey P.C. and take the first step towards regaining control of your financial future. Call us at 631-549-7900 for reliable debt relief counsel or contact us online.