Bankruptcy and Tax Debt: What You Need to Know

If you have thought about bankruptcy, chances are that your understanding of bankruptcy is that filing for bankruptcy will eliminate your debts and give you a clean slate moving forward. While it’s definitely true that bankruptcy can provide a fresh start, it’s important to understand that not all debts are forgivable in a bankruptcy filing and that for some types of debt, what you can discharge depends on the type of bankruptcy for which you file.

When it comes to tax debt, there’s a common misconception that if you have tax debt and file for bankruptcy, the government will forgive all of your debts—including your tax debt. Unfortunately, this just isn’t necessarily true. Here’s what you should know about bankruptcy and tax debt—remember, it’s always good to talk to a professional before filing for bankruptcy.

Can You Discharge Tax Debt?

If you are filing for bankruptcy and have tax debt, there are only certain situations in which you may be able to discharge your tax debt. In fact, you can only discharge tax debt if the following criteria are satisfied:

• The tax debt is only for income tax. If you owe taxes for anything other than taxes on earned income, you cannot discharge it in a bankruptcy filing.
• The tax debt occurred as a result of an honest mistake or debt—it cannot have occurred out of willful evasion or tax fraud.
• You filed a tax return for the tax debt that you are trying to discharge. In some courts, you can’t discharge debt even if you filed a late return, so make sure you ask the legal professional you’re working with if this applies to you.
• The tax debt must be at least three years old.
• Enough time must have passed. The IRS maintains what’s known as the 240-day rule, which means that the income tax debt must have been assessed at least 240 days before you file for bankruptcy.

Only if your debts meet all of the criteria above may they qualify for discharge during bankruptcy.

What About a Tax Lien?

If you fail to pay a tax debt, the government may issue what’s known as a tax lien. A tax lien is the government’s claim against your property. If the tax debt isn’t repaid, the lien gives the government the right to seize the debtor’s property. If the debtor does repay the debt, then the tax lien may be removed.

The bad news about having a tax lien—even if you’ve repaid it or are in the process of repaying it—is that you cannot discharge a federal tax lien, even if the tax debt meets the criteria for discharge listed above. That’s because the purpose of bankruptcy is to wipe away a personal tax, not to wipe out tax liens recorded prior to the bankruptcy filing.

Discharging Tax Debt and Chapter 13 vs. Chapter 7 Bankruptcy

The primary difference between a Chapter 13 and a Chapter 7 bankruptcy is that you must pass the means test to qualify for a Chapter 7 bankruptcy. With a Chapter 7 bankruptcy, your non-exempt assets will be liquidated, and your remaining debts will be discharged; with a Chapter 13 bankruptcy, on the other hand, you will enter a repayment plan to pay back debts and, in exchange, will be able to keep more assets. So how does this apply to those who want to discharge tax debt?

With a Chapter 13 bankruptcy and tax debt, some dischargeable tax debts might be forgiven without any repayment depending on the amount of disposable income you have. In any case, you won’t incur any interest on the tax debt that you owe.

If you file for a Chapter 7 bankruptcy on the other hand, your debt will be discharged if your debt meets the qualifications listed above and if you pass the means test—an income assessment that determines whether you have enough disposable income to pay back any portion of your existing debts.

Learn More About Bankruptcy and Tax Debt

If you are in a financial situation where bankruptcy is your best option, it’s important that you understand what debts may be dischargeable and how what you currently earn will impact which type of bankruptcy you file for, and how much of your overall debt is dischargeable. If you have questions about tax debt, you should consult with a financial professional or a bankruptcy lawyer. Filing for bankruptcy is a huge decision that will have a long-term impact on your financial health. Learn as much as you can before filing and explore all of your options in advance.