What is tax bankruptcy?

Tax debts—along with mortgage, credit card, car loan, and student loan debt—are one of the most common types of individual debt. Tax debts are an especially common reality for many as they prepare their income tax returns ahead of the April 15 filing deadline.

Regardless of the type of debt a person has, when individuals find themselves facing higher debt payments than they can afford to make, they may turn to bankruptcy as a solution. Individuals may not be aware that tax debts, like many other kinds of debt, are dischargeable in bankruptcy depending on the individual's circumstances and the type of bankruptcy.

Following is an overview of when individuals may use bankruptcy to discharge tax debt, situations when individuals cannot use bankruptcy to discharge tax debt, and what to do when an individual cannot eliminate tax debt with bankruptcy.

When can an individual discharge tax debt through bankruptcy?

Individuals can use Chapter 7 bankruptcy to discharge tax debt when their tax debt meets all of the following requirements:

  • The tax debt comes from income taxes, whether state or federal.
  • The tax debt does not stem from a fraudulent tax return or an attempt by the individual to evade tax debt or the filing of a tax return.
  • The tax debt stems from a tax return that was due three or more years before the date when the individual files bankruptcy.
  • The individual filed a tax return related to the tax debt two or more years before the date when the individual files bankruptcy.
  • The state or federal tax authority recorded the tax debt against the individual 240 or more days before the date when the individual files bankruptcy.

In a Chapter 13 bankruptcy, individuals may have to repay only a portion of the tax debt if the bankruptcy court classifies the tax debt as a non-priority tax debt. Non-priority tax debt is tax debt that meets all of the above requirements.

The percent of tax debt that an individual must repay will vary based on the individual's circumstances and bankruptcy plan. An individual must repay the agreed-upon amount of tax debt over the length of the bankruptcy repayment plan, which is typically three or five years.

In what situations are individual tax debts not dischargeable through bankruptcy?

An individual cannot discharge tax debt through Chapter 7 bankruptcy if the debt stems from income taxes and does not meet the five requirements noted in the previous question.

In addition, while a Chapter 7 bankruptcy can eliminate an individual's personal responsibility to repay an income tax debt, the bankruptcy will not remove or eliminate a tax lien recorded against the individual's property. Therefore, while the IRS or other tax authority cannot pursue the individual's income or bank balances to satisfy the tax debt, the individual will have to pay off the tax lien in order to sell the property.

Most other types of non-income tax debt are not dischargeable in bankruptcy. These tax debts commonly include but may not be limited to property taxes within one year of assessment, payroll taxes, and tax penalties.

What options are available to an individual who cannot discharge tax debts through bankruptcy?

In the case of tax debts that an individual cannot discharge through bankruptcy, the options available to the individual may vary depending on the tax authority involved. Two common options used by tax authorities, including the IRS, include a payment plan and an offer in compromise.

A payment plan—also known as an installment agreement—refers to the individual making a series of monthly payments to the tax authority until the individual has paid the tax debt owed in full. Typically, the tax authority will charge fees to set up the payment plan, as well as penalties and interest on the unpaid balance of the debt.

An offer in compromise refers to when the tax authority is willing to accept less than the full amount owed to consider the tax debt paid in full. Tax authorities will have very stringent asset and income requirements that an individual must meet in order to consider an offer in compromise from the individual.

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