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Tax Controversy & Resolution: Bankruptcy & IRS Tax Discharge

IRS Tax Discharge: Bankruptcy Implications

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In certain situations, delinquent taxes may be discharged through a bankruptcy. Taxpayers with limited income remaining at the end of each month and minimal assets usually choose to file for Chapter 7 bankruptcy (discharges qualifying debt) in potentially 4-6 months to discharge prior debt owed to creditors. Taxpayers who earn a significant income and/or who want to protect valuable assets may instead file for Chapter 13 bankruptcy. In exchange for Chapter 13 bankruptcy debt relief, these filers generally pay their discretionary income to their creditors over the course over an agreement repayment plan (e.g. 3-5 years). For many individuals, the most common type of bankruptcy is a Chapter 13.

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Partnerships and corporations file bankruptcy under Chapter 7 or Chapter 11 of the bankruptcy code. Individuals may also file under Chapter 7 or Chapter 11. A case filed under Chapter 11 of the bankruptcy code is frequently referred to as a “reorganization.” It is used primarily by incorporated businesses. However, individuals whose debt exceeds the maximum limit for Chapter 13 may file Chapter 11. The debtor uses the time from their bankruptcy filing to the confirmation of their debt repayment plan to reorganize their finances. Failure to successfully reorganize and get a debt repayment plan approved may result in a Chapter 11 case being converted to a liquidating Chapter 7.

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Other types of bankruptcy include Chapters 9, 12 and 15. Cases under these chapters of the bankruptcy code involve municipalities, family farmers and fisherman, and international cases. For information see Other Types of Bankruptcy – Chapters 9, 12 & 15.

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For additional tax information on bankruptcy, refer to Publication 908, Bankruptcy Tax Guide and Publication 5082, What You Should Know about Chapter 13 Bankruptcy and Delinquent Returns

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Generally, the following criteria must be met to discharge delinquent tax debt through a bankruptcy:

  • Tax returns were filed more than two years prior to the bankruptcy filing.

  • The tax liability was assessed more than 240 days prior to filing of the bankruptcy petition. 

  • ​The liability is not due on Trust Fund Tax (e.g. FICA, Medicare)

  • The taxpayer did not attempt to evade or defeat the tax, nor was the tax liability due to a fraudulent tax return.

  • The tax was not assessable at the time of the filing of the bankruptcy petition.

  • The tax was unsecured.

  • It has been more than 3 years since the returns were last DUE to be filed (including extensions).

  • The returns were timely filed or it has been at least 2 years since the returns were filed.​​

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Chapter 7 Bankruptcy: Tax Implications

Chapter 7 bankruptcy discharge of income taxes generally extinguishes personal obligation to pay the applicable tax and prevents the taxing authority from seizing your bank account or garnish your wages. However, certain criteria must apply (as noted below) in order to discharge your personal liability as to applicable tax debts.

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Discharging debts for federal income taxes in Chapter 7 may apply based on the following:

  • The taxes are income taxes; 

    • Taxes other than income (e.g. payroll taxes, fraud penalties) may NOT be eliminated.

    • You cannot get rid of most non-income-related tax debts.

  • You did not commit fraud or willful evasion; 

  • The debt is at least three years old (tax return must have been originally due at least three years before you filed for bankruptcy);

  • The tax liability was assessed more than 240 days prior to filing of the bankruptcy petition; and 

  • ​You filed a tax return for the debt you wish to discharge at least two years before filing for bankruptcy.

    • Generally, 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.

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Nondischargeable Tax Debts in Chapter 7 include the following:

  • Tax Liens (secured taxes). Tax liens recorded against your property before you file for bankruptcy will generally remain attached. As such, although you may not be personally liable for the tax debt, you may have to pay off the lien from any profits when you sell the property.​

  • Recent Property Taxes. If a property tax is incurred before you file for bankruptcy and is payable within one year of your bankruptcy filing, the tax is nondischargeable. However, you may discharge your personal liability for property taxes that were payable (without penalty) more than one year before your bankruptcy filing. Note, most counties attach a lien to your property upon assessment or one year afterwards. So if you have a lien against your property for the property tax, that lien may remain after your Chapter 7 discharge (although your personal liability will be removed). 

  • Taxes a 3rd party is Required to Collect or Withhold ("Trust Fund Taxes"). This covers taxes such as FICA, Medicare, and income taxes that an employer must withhold from the wages of employees, and sales taxes paid by the debtor’s customers that the debtor is required to send to a governmental. Certain employment taxes, excise taxes, and custom duties, depending on specific time periods may also fall into this category.

  • Non-punitive Tax Penalties on Nondischargeable Taxes. If the transaction or event that derived the penalty occurred less than three years before filing the bankruptcy petition is generally nondischargeable.

  • Erroneous tax refunds or credits relating to nondischargeable taxes.

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Chapter 13 Bankruptcy: Tax Implications

In a Chapter 13 reorganization, the trustee doesn’t sell the debtor’s property. Instead, the debtor must develop a repayment plan with creditors over an agreed period. However, most Chapter 13 plans will include provisions that enable the debtor to pay creditors less than the amount owed, and be extinguished, depending on its debt classification (i.e. priority v. nonpriority tax).

 

Below outlines key points to evaluate when analyzing Chapter 13's tax implications.

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Important Considerations Before Filing Chapter 13:

  • You must file all required tax returns for tax periods ending within four years of your bankruptcy filing.

  • During your bankruptcy you must continue to file, or get an extension of time to file, all required returns.

  • During your bankruptcy filing you should pay all current taxes as they come due.

  • Failure to file returns and/or pay current taxes during your bankruptcy may result in your case being dismissed.

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Taxes in Chapter 13 Bankruptcy

Delinquent taxes must meet qualification requirements before getting discharged in a Chapter 13 case. Any portion failing to meet the requirements must generally be paid in full over a 3-5 year payment plan. In a Chapter 13 filing you must pay certain debts known as "priority claims" in full. 

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Below outlines different taxes issues and how they are impacted in a Chapter 13 bankruptcy.

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Income Taxes

If the tax is on income or gross receipts, you’ll start by determining whether it’s a priority or nonpriority debt.

 

Priority tax

  • Must be paid in full in the Chapter 13 plan.

  • Consists of recent income taxes (due within three years prior to filing bankruptcy).

  • Includes child support and alimony arrearages, and most tax obligations.

  • Trust fund taxes (FICA, Medicare, and income taxes that you withhold from an employee's paycheck).

  • Sales tax collected from customers.

  • Certain employment taxes, excise taxes, and custom duties.

  • Tax penalties for nondischargeable taxes.

  • Erroneous tax refunds or credits relating to nondischargeable taxes.

  • Recent property taxes.

 

Nonpriority Tax

  • Gets lumped with other unsecured debt (like credit cards and medical bills).

  • Unsecured creditors must share your “discretionary income,” or the amount remaining after deducting allowed living expenses and payments (such as your house and car payment). Because you pay only your discretionary income to this group, it's likely that you won’t have to pay all your nonpriority tax debt.

  • In general, nonpriority taxes meet the following criteria:

    • (1) The taxes are on income or gross receipts.

    • (2) The income taxes were due at least three years (including valid extensions) before you filed the bankruptcy.

    • For instance, your tax return for 2014 was due on October 15, 2015, after you requested an extension. That tax would not be considered a priority tax in a bankruptcy case filed on October 16, 2018, or later. If your return was due on April 15, 2016, the taxes would be priority taxes in any case filed before April 16, 2019.

    • (3) You filed your tax return at least two years before you filed the bankruptcy case.

    • If you did not file a timely return or if the IRS filed a substitute return for you, some bankruptcy courts have held that those taxes remain priority forever.

    • (4) The taxing authority assessed the tax liability at least 240 days before you filed your bankruptcy case. This period can be lengthened in certain cases.

    • (5) You didn’t commit fraud or willfully evade paying your taxes for the tax year in question.

  • If you don’t meet the criteria noted above, your tax may be considered a priority tax that will have to be paid in full in your Chapter 13 plan. In order to appropriately classify different tax liabilities, a bankruptcy attorney should be consulted to help determine the priority status of your tax liabilities.

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Federal Tax Lien

A federal tax lien is a legal claim by the government against your property when you neglect or fail to pay a tax debt. The lien protects the government’s interest in all your property, including real estate, personal property and financial assets. In general, a federal tax lien exists after the IRS records your balance due on their records to assess your liability and sends you notification (Notice and Demand for Payment) regarding how much you owe and you neglect or refuse to fully pay the debt in time.

 

The IRS files a public document, the Notice of Federal Tax Lien, to alert outside creditors that the government has a legal right to your property. If your tax debt is a secured liability (taxing authority took an ownership interest in your property) then you may not be able to discharge the obligation. For example, in a Chapter 13 filing, you will likely have to pay off the entirety of a tax lien, filed by the taxing authority to secure payment, over the course of the plan.​

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How to Get Rid / Resolve a Tax Lien

  • Paying your tax debt. The IRS releases your lien within 30 days after you have paid your full tax debt. When conditions are in the best interest of both the government and the taxpayer, other options for reducing the impact of a lien exist.

  • Discharge of property. A "discharge" removes the lien from specific property. There are several Internal Revenue Code (IRC) provisions that determine eligibility.

    • See Publication 783, Instructions on How to Apply for Certificate of Discharge From Federal Tax Lien (PDF).

  • Subordination. "Subordination" does not remove the lien, but allows other creditors to move ahead of the IRS, which may improve potential to obtain a loan and/or mortgage.

  • Withdrawal. A "withdrawal" removes the public Notice of Federal Tax Lien and assures the IRS is not competing with other creditors for your property. However, you are still liable for the amount due.

    • For eligibility, refer to Form 12277, Application for the Withdrawal of Filed Form 668(Y), Notice of Federal Tax Lien (Internal Revenue Code Section 6323(j)).​

    • Two additional Withdrawal Options  - IRS Commissioner’s 2011 "Fresh Start" Initiative

      • (1) Withdrawal of your Notice of Federal Tax Lien After the Lien’s Release.

        • General eligibility includes:

          • Your tax liability has been satisfied and your lien has been released;  

          • You are in compliance for the past three years in filing (all individual, business, and information  returns; and 

          • You are current on your estimated tax payments and federal tax deposits (as applicable).

      • (2) Withdrawal of your Notice of Federal Tax Lien if Entered or Converted your Regular Installment Agreement to a Direct Debit Installment Agreement.

        • General eligibility includes:

          • You are a qualifying taxpayer (i.e. individuals, businesses with income tax liability only, and out of business entities with any type of tax debt);

          • You owe $25,000 or less (If you owe more than $25,000, you may pay down the balance to $25,000 prior to requesting withdrawal of the Notice of Federal Tax Lien);

          • Your Direct Debit Installment Agreement must full pay the amount you owe within 60 months or before the Collection Statute expires (whichever is earlier);

          • You are in full compliance with other filing and payment requirements;

          • You have made three consecutive direct debit payments; and

          • You have not defaulted on your current, or any previous, Direct Debit Installment agreement.

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How a Tax Lien Affects You & Your Business

  • Assets: A lien attaches to all of your assets (such as property, securities, vehicles) and to future assets acquired during the duration of the lien.

  • Credit: Once the IRS files a Notice of Federal Tax Lien, it may limit your ability to get credit.

  • Business: A lien may attaches to all business property and to all rights to business property, including accounts receivable.

  • Bankruptcy: If you file for bankruptcy, your tax debt, lien, and Notice of Federal Tax Lien may continue after the bankruptcy.

  • Lien vs. Levy: A lien is not a levy.

    • A lien secures the government’s interest in your property when you do not pay your tax debt.

    • A levy actually takes the property to pay the tax debt. If you don’t pay or make arrangements to settle your tax debt, the IRS can levy, seize and sell any type of real or personal property that you own or have an interest in.

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IRS Resources

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