Tax Debts and Bankruptcy

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Tax Debts and Bankruptcy

Bankruptcy

Does bankruptcy clear tax debt? It depends on the type of tax debt and specific conditions. This article will explain which tax debts can be discharged, the criteria to discharge tax debt, and the impact of different bankruptcy chapters on tax debt.

Key Takeaways

  • Bankruptcy can discharge certain types of tax debt, primarily income tax, if specific conditions are met, such as the age of the debt and filing history. Understanding these conditions is crucial to eliminate tax debt through bankruptcy.
  • Federal tax liens remain attached to property even after bankruptcy discharge, complicating asset sales. Careful management of tax liens is essential.
  • Alternatives to bankruptcy, such as IRS installment agreements and offers in compromise, can provide viable options for managing tax debt without filing for bankruptcy.

The Role of Bankruptcy in Society

bankruptcy court

Bankruptcy plays a crucial role in the financial world by providing individuals and businesses with a structured mechanism to address overwhelming debts. It acts as a safety net, offering a fresh start to those facing painful financial challenges, while also ensuring that creditors receive some form of repayment. By balancing the interests of debtors and creditors, bankruptcy helps maintain economic stability and encourages responsible financial practices.

For individuals, bankruptcy can alleviate the burden of excessive debt, allowing them to regain control over their personal finances and work towards a more secure future. For businesses, it provides an opportunity to restructure and continue operations, preserving jobs and contributing to the economy.

Does Bankruptcy Clear Tax Debt?

Tax debts come in various forms, including income tax, capital gains tax, self-employment tax, tax penalties and interest. The bankruptcy rules for each type of tax debt are complicated.

Federal income tax debt can be discharged by bankruptcy, but only under very specific conditions. Successfully eliminating tax debt through bankruptcy requires meeting qualifications such as the timing of the debt, filing valid returns, and understanding the implications of tax liens.

Payroll taxes, sales taxes, certain property taxes, tax debts arising from fraud, and tax penalties related to FICA and Medicare taxes cannot be discharged by bankruptcy. These tax debts must be paid regardless of a bankruptcy filing.

In all cases, be sure to consult with a bankruptcy attorney before making any decisions regarding this area of the law.

Overview of Bankruptcy Chapters

There are three types of bankruptcy proceedings, each with its own set of laws and procedures. Here is a very general summary of these three types of bankruptcy:

  • Chapter 7 bankruptcy, often referred to as liquidation bankruptcy, involves selling the debtor’s assets to pay creditors. This process can provide a fresh financial start for individuals and businesses overwhelmed by debt, as it allows for the discharge of eligible debts, including certain types of tax debts. However, it’s important to note that not all assets are required to be sold under Chapter 7 bankruptcy. Exemptions may protect some property from liquidation.
  • Chapter 11 bankruptcy, often used by corporations and larger businesses, allows the filer to discharge certain debts (including certain taxes) and then reorganize the remaining debts into a plan of repayment. Repayment arrangements are generally up to five years. The plan is overseen by a bankruptcy trustee. It provides a way for businesses to continue operating, rather than liquidating their assets entirely.
  • Chapter 13 bankruptcy is a plan of reorganization for individuals. It focuses on debt adjustment, allowing individuals to keep their assets while repaying debts over time through a court-approved repayment plan. This plan typically spans three to five years, during which time the debtor makes regular payments to a trustee who then distributes the funds to creditors. Chapter 13 bankruptcy can be particularly beneficial for individuals with steady income who wish to retain their property, including homes and cars, while systematically addressing their debts, including tax obligations.

The Automatic Stay

bankrupt

When you file for bankruptcy, an automatic stay is immediately put into effect, providing significant relief from the collections activity of creditors. This provision halts lawsuits, wage garnishments, and harassing phone calls. It is important to note that an automatic stay generally stops the collection efforts of the IRS and the state department of revenue, including the seizure of bank account funds.

For individuals struggling with overwhelming tax debts, the automatic stay can offer a much-needed reprieve, allowing them to focus on sorting out their financial situation without constant pressure from creditors. The automatic stay is particularly beneficial for those facing imminent foreclosure or repossession, as it temporarily prevents these actions from proceeding.

However, there are a few exceptions to the automatic stay when it comes to taxes. For example, audits and demands for tax returns may still continue.

The Role of Federal Tax Liens in Bankruptcy

bankruptcy

A federal tax lien is a legal claim by the government against your property when you fail to pay a tax debt. It arises when the IRS assesses your tax liability and sends you a bill that you neglect to pay. The lien protects the government’s interest in all your property, including real estate, personal property, and financial assets.

Once a federal tax lien is in place, it can significantly impact your financial situation. It may affect your ability to sell or refinance your property, as the lien must typically be resolved before any transaction can occur. Additionally, a tax lien may appear on your credit report, potentially lowering your credit score and affecting your ability to secure loans.

In bankruptcy proceedings, an automatic stay does not eliminate tax liens already in place. If the IRS recorded tax liens on your property before bankruptcy, these liens remain attached to the property even after your personal liability is discharged. This means you cannot sell the property without first settling the lien.

Chapter 7 Bankruptcy and Tax Debt

The issue of discharging taxes in bankruptcy is complicated by a series of highly-specific rules. When filing bankruptcy, it is important to understand that most tax debts cannot be eliminated. All of these rules must be satisfied in order to discharge a tax debt. The following is a summary of the tax rules that apply to Chapter 7 bankruptcy:

The Three-Year Rule

The “Three-Year Rule” stipulates that the tax debt must be at least three years old from the original due date of the tax return. It does not matter when the return was filed.

For instance, if you owe taxes for a return due on April 15, 2020, you would need to wait until at least April 15, 2023, to include that tax debt in a Chapter 7 bankruptcy filing. This rule ensures that only older tax debts, which the taxpayer has had ample time to address, can be considered for discharge.

The 240-Day Rule

The tax debt must have been assessed by the IRS at least 240 days before the bankruptcy filing. This period is extended if there was a pending offer in compromise.

The Two-Year Rule

This rule requires that the taxpayer must have filed the tax return at least two years before the bankruptcy filing date.

For example, if you filed your tax return on April 15, 2021, you would need to wait until at least April 15, 2023, to include that tax debt in a Chapter 7 bankruptcy filing.

The Non-Fraudulent Return Rule

To have tax debts discharged, the taxpayer must have filed a non-fraudulent tax return. This means that the tax return may not contain any false information or attempts to deceive the taxing authorities. If the return is found to be fraudulent, the associated tax debts will not be eligible for discharge in bankruptcy.

Fraudulent tax returns involve deliberate misrepresentations, such as underreporting income or inflating deductions, with the intent to evade taxes.

The Non-Tax Evasion Rule

Under this rule, tax debts cannot be discharged in bankruptcy if the debtor is found to have willfully evaded paying taxes. Tax evasion involves intentionally avoiding tax payments through deceitful actions such as underreporting income, hiding assets or falsifying records.

Unassessed Income Tax

This rule refers to tax liabilities that the IRS has not yet formally assessed against a taxpayer. The IRS must first complete the assessment process before these liabilities can be considered for discharge in bankruptcy.

For example, if you filed your tax return but the IRS has not yet processed it, any taxes owed from that return are considered unassessed and may not be discharged in bankruptcy.

Payroll, Withholding and Other Trust Fund Taxes

Payroll taxes, withholding taxes, sales taxes and other “trust fund taxes” are non-dischargeable in bankruptcy. These taxes are held in trust for the government. Because they are considered a fiduciary responsibility, these taxes cannot be eliminated through bankruptcy proceedings.

Property Taxes Assessed More Than One Year Before Bankruptcy

Property taxes assessed without penalty more than one year before the bankruptcy petition date are eligible for discharge in bankruptcy. In contrast, property taxes assessed without penalty within one year of the petition date are not eligible for discharge in bankruptcy.

Employment, Excise Taxes, and Custom Duties

Employment and excise taxes that are imposed within three years of filing a bankruptcy petition may not be discharged in bankruptcy. Examples of excise taxes include gift, estate and highway use taxes.

Also, customs duties arising out of the importation of merchandise are not dischargeable in bankruptcy.

Gap Claims

Gap claims refer to the period between the filing of a bankruptcy petition and the issuance of an order for relief by the bankruptcy court. During this interval, certain claims may arise that are considered “gap claims.” These claims are given priority in bankruptcy proceedings, as they occur after the filing but before the official commencement of the bankruptcy case. They may not be discharged in bankruptcy.

Taxes and Chapter 11 and 13 Bankruptcy Filings

Chapter 11 and Chapter 13 bankruptcy provide a structured approach to managing tax debts, including federal income taxes, even when the IRS is otherwise unwilling to negotiate payment arrangements. By allowing taxpayers to establish an installment agreement through the bankruptcy court, these chapters offer a powerful alternative to direct negotiations with the IRS. This can be particularly beneficial when the IRS is resistant to further discussions or when previous attempts to negotiate have failed.

Alternatives to Bankruptcy for Tax Debt

Before deciding on bankruptcy, consider exploring alternatives that might better suit your situation. A CPA or a bankruptcy attorney can clarify whether bankruptcy or an alternative solution is more beneficial for managing your tax debts.

IRS Installment Agreements

An IRS installment agreement is a viable alternative to bankruptcy for managing tax debt. These plans allow you to pay off your tax debt over time, making it more manageable without the need to file for bankruptcy. By entering into an installment agreement, taxpayers can avoid the immediate financial strain of paying a large sum upfront, which is often a requirement in bankruptcy proceedings.

The IRS offers several types of installment agreements, tailored to meet different financial situations. For instance, a streamlined installment agreement is available for taxpayers who owe a relatively modest amount and can repay it within a short period. For those with larger tax debts, the IRS may offer a long-term installment plan, allowing payments over several years.

To qualify for an installment agreement, taxpayers must be up-to-date with all tax filings and demonstrate their ability to make regular payments. The IRS evaluates the taxpayer’s financial situation, including income, expenses, and assets, to determine an appropriate monthly payment amount. It’s crucial for taxpayers to propose a realistic payment plan that aligns with their financial capacity to avoid defaulting on the agreement.

One of the key benefits of an IRS installment agreement is that it can halt other collection activities, such as wage garnishments or bank levies, providing taxpayers with relief from immediate financial pressure. However, interest and penalties continue to accrue on the unpaid tax balance, so it’s in the taxpayer’s best interest to pay off the debt as quickly as possible.

Taxpayers should be aware that failing to adhere to the terms of an installment agreement can result in the IRS reinstating collection activities. Additionally, tax refunds may be applied to the outstanding tax debt, reducing the balance owed. Therefore, maintaining consistent payments and staying current with future tax obligations is essential to keep the agreement in good standing.

Offers in Compromise

Negotiating an offer in compromise can potentially reduce the total tax debt owed to the IRS. To qualify, you must demonstrate financial hardship, making this an attractive option for those who cannot pay their tax debts in full. The IRS carefully evaluates each offer to ensure it aligns with their criteria, which includes the taxpayer’s ability to pay, income, expenses, and asset equity. The goal is to determine a reasonable amount that the taxpayer can pay based on their financial situation.

It’s important to note that securing an offer in compromise is not guaranteed, and the process can be lengthy, often taking several months for the IRS to review and respond. Applicants need to provide comprehensive financial documentation to support their case for financial hardship.

Additionally, taxpayers who are granted an offer in compromise must comply with all future tax obligations, including filing returns and making payments on time for a specified period. Failure to adhere to these conditions can result in the offer being revoked, and the original tax debt may be reinstated.

Currently Not Collectible Status

Currently Not Collectible (CNC) status is an option provided by the IRS for taxpayers who are unable to pay their tax debt due to financial hardship. When granted CNC status, the IRS temporarily suspends collection activities, such as wage garnishments or bank levies, allowing the taxpayer some breathing room to stabilize their financial situation. It’s important to note that CNC status does not eliminate the tax debt; interest and penalties continue to accrue during this period.

To qualify for CNC status, taxpayers must demonstrate that paying the tax debt would create a significant financial hardship, preventing them from meeting basic living expenses. This typically involves providing detailed financial information to the IRS, including income, expenses, and asset details. The IRS reviews this information to determine eligibility for CNC status.

While in CNC status, taxpayers are encouraged to continue filing their tax returns on time and to pay any new tax liabilities as they arise. The IRS periodically reviews CNC accounts to assess whether the taxpayer’s financial situation has improved to the point where they can begin repaying the tax debt.

Penalty Abatement

Penalty abatement is an option for taxpayers seeking relief from IRS-imposed penalties that have compounded their tax debt. These penalties can arise from various issues, such as failing to file a tax return on time, failing to pay taxes owed, or inaccuracies in tax filings. The IRS offers penalty abatement as a way to alleviate the financial burden on taxpayers who can demonstrate reasonable cause for their non-compliance.

To qualify for penalty abatement, taxpayers must provide a valid reason for their inability to comply with tax obligations. Common reasons accepted by the IRS include natural disasters, serious illness, or the death of an immediate family member. Additionally, taxpayers who have a history of compliance and have corrected their filing or payment issues may also be eligible for penalty relief.

There are different types of penalty abatement, including First-Time Penalty Abatement (FTA), which is available to taxpayers who have a clean compliance history for the past three years. The FTA is a one-time waiver that can be applied to late filing, late payment, or failure-to-deposit penalties.

Taxpayers seeking penalty abatement should submit a request to the IRS, either through a written letter or by calling the IRS directly. The request should include a detailed explanation of the circumstances that led to the penalties and any supporting documentation. It’s important for taxpayers to continue fulfilling their tax obligations during the abatement process to avoid further penalties.

Summary

Bankruptcy and tax debts can be complex, but understanding the nuances of dischargeable and non-dischargeable debts, the impact of federal tax liens, and the differences between Chapter 7, 11 and 13 bankruptcies is important. Whether you choose bankruptcy or alternatives like IRS installment agreements or offers in compromise, informed decisions can lead toward financial relief.

A good place to start the process is by talking with a CPA who is experienced with tax resolution and tax negotiation matters. If bankruptcy is a serious option, then you will need to consult with a bankruptcy attorney as well.

Frequently Asked Questions

Can bankruptcy clear all types of tax debt?

Bankruptcy cannot clear all types of tax debt; only certain income tax debts may be discharged under specific conditions. It is essential to consult a tax professional or bankruptcy attorney for guidance tailored to your situation.

How does a federal tax lien affect my bankruptcy case?

A federal tax lien will continue to affect your property during and after bankruptcy, requiring settlement before any asset sale can occur. Thus, it is crucial to address the lien in your bankruptcy case to avoid complications.

What is the difference between Chapter 7 and Chapter 13 bankruptcy regarding tax debts?

The primary difference is that Chapter 7 bankruptcy involves liquidating assets to settle debts, while Chapter 13 bankruptcy enables individuals to gradually repay tax debts and retain their assets. Thus, Chapter 13 may be more beneficial for those wishing to preserve their property while managing tax obligations.

Are payroll taxes dischargeable in bankruptcy?

Payroll taxes are not dischargeable in bankruptcy, as they are considered non-dischargeable tax debts.

What alternatives to bankruptcy can help manage tax debt?

IRS installment agreements and offers in compromise are effective alternatives to bankruptcy for managing tax debt, permitting structured repayment or potential reduction of the amount owed. These options can provide a viable path forward without the severe consequences of bankruptcy.

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Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country.  Our services include tax return preparation, tax planning for businesses and individuals, estates and trusts, IRS tax problem resolution, IRS audits, sales taxes and small business accounting and bookkeeping. 

Massey and Company CPA

Based in Atlanta and Chicago, Massey and Company CPA specializes in tax and accounting matters of small businesses, entrepreneurs, and their families.
 
We do everything related to tax return preparation and tax planning, as well as accounting and bookkeeping for small businesses using QuickBooks Online.
 
In addition, we represent taxpayers before the IRS, keeping taxpayers out of tax trouble. We negotiate with the IRS and the state, so you do not have to.
 
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