Tax Liabilities and Bankruptcy

Despite what you may have heard in commercials, eliminating tax liabilities in bankruptcy is not as simple as it sounds. You cannot wipe out most tax bills in bankruptcy. The tax liability will still be there at the end of a Chapter 7 bankruptcy, or you will have to repay it in full in a Chapter 13 bankruptcy repayment plan.

Chapter 7 and Chapter 13 Bankruptcy

A Chapter 7 bankruptcy is likely the better option if you need to discharge tax liabilities – although only if your liabilities qualify for discharge and you are eligible for Chapter 7 bankruptcy. Two qualifiers that unfortunately eliminate the majority of people looking to discharge tax liabilities.

What is Chapter 7 Bankruptcy?

Of all filings, Chapter 7 bankruptcy has been the most common form since 1994.

Chapter 7 filing made up almost 62% of all filings in 2018, with close to half a million people choosing it over all other types of bankruptcy.

Essentially, Chapter 7 bankruptcy allows a taxpayer, if willing, the ability to give up their nonexempt property to be sold to creditors, and in exchange, the court will erase the taxpayer’s dischargeable debts.

What is Nonexempt Property?

There is a balancing act to Chapter 7 bankruptcy.

If you have too much property that is nonexempt, the bankruptcy trustee will liquidate (sell) your ‘excess’ or nonexempt property. Chapter 7 bankruptcy is sometimes called liquidation bankruptcy.

List of Exempt Property

In almost every state, there are common properties that are exempt from creditors.

  • Equity in a home, known as the homestead exemption
  • Equity in a motor vehicle
  • Reasonably necessary clothing
  • Reasonably necessary household furnishings and appliances
  • Jewelry (to a set value) and personal effects
  • Tools or equipment related to a profession or trade

Various intangible property is also exempt to a certain value.

  • Life insurance
  • Retirement funds
  • Unpaid but earned wages
  • Public benefits such as Social Security, welfare, and unemployment compensation

What is Chapter 13 Bankruptcy?

Chapter 13 bankruptcy enables you to develop a payment plan, much like an IRS Installment Agreement, with your creditors to repay all or part of your debt. Depending on your monthly income, and if it is above or below the state median, you will either be on an installment plan for three or five years.

Chapter 13 also allows you to stop foreclosure proceedings and cure delinquent mortgage payments. This aspect of Chapter 13 is unavailable to a Chapter 7 filer.

When Discharging a Tax Liability is Allowed

You can discharge (wipe out) liabilities for federal income taxes in Chapter 7 bankruptcy only if all of the following conditions are true:

The taxes are income taxes. Taxes other than income, such as payroll taxes or fraud penalties, can never be eliminated in bankruptcy.

You did not commit fraud or willful evasion. If you filed a fraudulent tax return or otherwise willfully attempted to evade paying taxes, such as using a false Social Security number on your tax return, bankruptcy can’t help.

The bill is at least three years old. Meaning, to eliminate tax liabilities, the tax return in question had to have been due at least three years before you filed for bankruptcy.

You filed a tax return. You must have filed a tax return for the liability you wish to discharge at least two years before filing for bankruptcy.

In most courts, if you file a late return (meaning your extensions have expired and the IRS filed a substitute return on your behalf), you have not filed a “return” and cannot discharge the tax. In some courts, you can discharge tax liability that is the subject of a late return as long as you meet the other criteria.

You pass the “240-day rule,” in which case the IRS assessed the income tax bill at least 240 days before you filed your bankruptcy petition, or the IRS did not assess your income tax bill yet. This time limit will extend if the IRS suspended collection activity because of an offer in compromise or a previous bankruptcy filing.

Federal Tax Lien Are Not Eligible To Be Discharged

If your taxes qualify for discharge in a Chapter 7 bankruptcy case, your victory may be bittersweet. Bankruptcy will not wipe out prior recorded tax liens.

A Chapter 7 bankruptcy will wipe out your obligation to pay the bill and prevent the IRS from going after your bank account or wages. But, if the IRS recorded a tax lien on your property before you filed for bankruptcy, the lien will remain on the property. In effect, this means you’ll have to pay off the tax lien to sell the property.

Next Steps

To find out more about which liabilities you can eliminate in bankruptcy, feel free to contact us at 833-419-RISE (7473). Our Tax Resolution Experts will be happy to help you.

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