Does Bankruptcy Clear Tax Debt? What You Need to Know

Bankruptcy is a legal process for individuals or businesses that cannot pay their debts. It starts when the debtor files a petition or sometimes when creditors do. The purpose of bankruptcy is to help the debtor pay or restructure their debts when they can no longer meet their financial obligations. By relieving the debtor of their financial burdens, bankruptcy gives them a chance to start fresh. While bankruptcy can eliminate many debts, getting rid of tax debts through bankruptcy can be complex. Tax debts have specific rules, so filing for bankruptcy may not always help clear them. Before discussing how bankruptcy can address tax debt, it’s essential to understand whether bankruptcy can remove tax debts.

How Bankruptcy Affects Tax Debt

Bankruptcy can help you get relief from specific debts, but the rules about tax debt are complicated. Whether you can wipe out your tax debt by filing for bankruptcy depends on what kind of taxes you owe, how long you have owed them, and if you meet certain conditions. Tax debts fall into two categories: dischargeable and non-dischargeable. Dischargeable tax debts can be eliminated in bankruptcy. Examples of dischargeable tax debt include federal or state income tax debts. Non-dischargeable tax debts cannot be cleared through bankruptcy. These include trust fund taxes, recent property taxes, tax liens, and non-income taxes.

Does Bankruptcy Clear Tax Debt?

The question, 'Does bankruptcy clear tax debt?' is rightly answered in the affirmative. Bankruptcy can eliminate certain tax debts if you meet specific criteria. Generally, the tax debts that can be discharged include federal or state income taxes. To qualify for the discharge of tax debt in bankruptcy, you need to meet these three requirements:

• You must have filed all required tax returns for tax periods ending within the last four years before your bankruptcy filing.
• You should continue to file your tax returns or request an extension during your bankruptcy case.
• You must pay all current taxes due during your bankruptcy proceedings.

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

Types of Bankruptcy: Chapter 7 vs. Chapter 13

There are two types of bankruptcy for anyone seeking to discharge their tax debt: Chapter 7 and Chapter 13.

Chapter 7seven bankruptcy is intended for individuals and businesses that cannot resolve their financial problems. In this process, assets are sold to pay off debts. Once the liquidation is complete, eligible debts that are left may be discharged.

On the other hand, Chapter 13 bankruptcy is for individuals with a regular income who feel overwhelmed by debt but believe they can manage their payments over time. This option allows the debtor to retain their properties while setting up a repayment plan. This plan allows the debtor to pay off their debts within three to five years. The main differences between the two types of bankruptcy are how they handle the debtor's properties, which debts qualify, and whether the debtor can improve their financial situation.

Conditions for Discharging Tax Debt in Bankruptcy?

There are specific conditions that must be met to discharge federal income taxes through bankruptcy. These conditions include: 

• The tax debt must be at least three years old. 
• The IRS must have assessed the income tax debt at least 240 days before you file for bankruptcy. 
• You must have filed a tax return at least two years before declaring bankruptcy. 
• You have never attempted to evade tax payment by filing a fraudulent tax return. Below is a detailed explanation of these conditions:

The 3-Year Rule

This Rule says that your tax return must be filed at least three years before you file for bankruptcy. To see if your tax debt qualifies, look back three years from the date you file for bankruptcy. Any tax return due after those three years is considered a priority debt. This means you cannot discharge the tax for that year in bankruptcy.

The 2-Year Rule

The two-year Rule states that the individual must file a valid tax return for the debt in the last two years before filing for bankruptcy. A valid tax return meets all the necessary filing rules under non-bankruptcy law. The debt cannot be discharged if you do not file a valid tax return.

The 240-Day Rule

This Rule requires that the IRS evaluate your tax debt 240 days before your bankruptcy petition is filed. This evaluation is done to determine how much tax you owe.

No Fraud or Tax Evasion

This Rule states that taxpayers' debt cannot be cleared if they commit fraud or attempt to evade paying taxes. 

What Happens To Tax Liens in Bankruptcy 

A tax lien is a legal claim against your property when you neglect or fail to pay a debt. Specifically, the IRS can place a lien on your property if you have unpaid tax debts. Tax liens do not suddenly disappear after a bankruptcy discharge. It remains enforceable if the IRS files a lien against your property before you file for bankruptcy. As such, even if your tax debt is discharged, the IRS still has the right to claim the value of the property secured by the lien.

Chapter 13 typically allows individuals to create and file an easy-to-work-with repayment plan. This eliminates the pressure that comes with paying the tax debt once. Here, the debtor only agrees to pay a certain percentage of their future income to the bankruptcy court trustees for debt payment. If the court approves the plan, the debtor will be protected by the court while repaying the debt, which means that the individual cannot be arrested or have their properties taken within the specified period.

Alternative Options For Managing Tax Debt

While specific eligibility requirements must be met to apply for the discharge of tax debt through bankruptcy, there are also other options for managing tax debt that do not have such strict conditions.

IRS Payment Plans

A repayment plan is an agreement with the IRS that lets you pay your tax debt over time. Once you set up this plan, the IRS will halt or extend collection efforts so you can make payments as agreed. If you miss a payment, the IRS may end the agreement. Also, be aware that you might have to pay setup fees if the IRS approves your payment plan.

Offer in Compromise 

An offer in compromise typically helps you avoid financial struggles caused by tax debt. Here, you suggest a payment amount to the IRS based on what you can afford, considering your assets, income, expenses, and future earning potential. If the IRS agrees that paying the full amount would cause you financial hardship, they may accept your offer. This means you can settle your tax debt for less than what you owe, allowing you to move forward.

Innocent Spouse Relief 

Innocent spouse relief provides protection from extra tax liabilities if your spouse has made mistakes on your joint tax return without your knowledge. This relief applies only to taxes on your spouse's income from a job or self-employment. You cannot use this relief for taxes related to:

• Your own income
• Household employment taxes
• Individual Shared Responsibility payments
• Business taxes
• Trust fund recovery penalties for employment taxes

Steps To Take Before Filing for Bankruptcy on Tax Debt 

Deciding if bankruptcy is the best choice for you is the first step to getting rid of your debts. Before you file for bankruptcy, it is important to understand your financial situation. Consulting a financial expert and a tax professional can help. They will review your debts, income, expenses, and assets. They can also help you figure out if you can discharge your tax debt.

Remember, it is essential to identify which tax debts qualify for discharge. It is best to seek professional guidance to deal with your tax liabilities effectively. This will help you choose the most appropriate financial strategy for managing your tax obligations.