Bankruptcy and Taxes
There is no shame in getting behind on your taxes. Whether you are an individual or a business, there can be a myriad of reasons why you might find yourself struggling with bankruptcy and taxes. A serious medical expense, natural disaster, or a family emergency can force you to put your taxes on the back burner and focus on what matters most. However, you can’t ignore the IRS forever. Sooner or later they will notify you of the actions they plan to take in order to reclaim the money that you or your business owes. The IRS can come after your finances and your assets in the form of a lien, wage garnishment, or seizure of property and assets. Of course, it takes a long time for the IRS to reach the point of seizing your assets and they will give you plenty of warning before doing so. However, you should never let your back tax debt reach this critical point. Once the IRS has taken your wages or assets it can be incredibly difficult if not impossible to get them back. If you are struggling to pay back the IRS and you don’t see any possible way to do so, filing bankruptcy may be the best option for you, and has proven to be for many Americans—in 2019, 773,361 people filed for bankruptcy.
Can you File Bankruptcy on Taxes?
Yes, you can file bankruptcy to resolve back taxes, but not for all of your tax debts. Every chapter has a different set of requirements and processes. Chapter 7 is often a “saving grace” for anyone in over their head with insolvency because it completely eliminates all dischargeable back tax debts. This strategy is used for those who are unable to pay back income tax debt; however, it is more difficult to get approved for than the other chapters of bankruptcy.
While you can file Chapter 7 for income tax debt, the same strategy will not work for payroll taxes. In addition, rules on previously unfiled tax returns are not uniform and newer liabilities are unable to be resolved. Chapter 7 is not the only way to handle bankruptcy and taxes with IRS, and you should consider other chapters before filing. Learning more about the different chapters of bankruptcy will help you determine which type can help you in your circumstances.
Does Bankruptcy Clear Tax Debt?
Filing for bankruptcy can clear tax debt depending on the nature and circumstances of your situation. Certain tax obligations may be discharged, forgiven, or managed in a bankruptcy filing. Here are some of the criteria that the IRS will consider when deciding whether or not you or your business is eligible for complete tax forgiveness.
- The dates you filed your required returns (if they were filed at all): The IRS is more likely to assist you when they see that you have made an effort to pay your taxes on time.
- The age of the taxes: The IRS is going to examine the date the returns were last due or meant to be filed.
- The date of assessment of the taxes.
- Willfulness: If the IRS has any reason to believe that you willfully attempted to evade payment of the tax by fraud they will immediately dismiss any tax forgiveness through bankruptcy.
Whether or not the IRS will grant tax bankruptcy discharge is directly tied to the above factors as well as any other miscellaneous factors that pertain to the particular chapter you choose to file under.
What are the Requirements for Tax Discharge?
There are a number of pre-requisites that have to be met before you can solve your bankruptcy tax debt. In order to be cleared of all income tax debt (state or federal), the following minimum requirements have to be met:
- 3 years need to have passed since your returns were last due to be filed—this includes any extensions that you may have received.
- The returns were filed in a timely manner or it’s been at least 2 years since the returns were filed.
- There was no fraud or attempts to avoid and evade paying the IRS (meaning you were able to pay but chose not to).
- The taxes haven’t been assessed in the last 240 days.
Sometimes, there are occasional exceptions and ways to get around the above requirements. You shouldn’t give up on filing for bankruptcy to absolve yourself of tax debt until you have a qualified professional take a look at your files first. Even if you can’t completely get rid of your tax debt through bankruptcy, you may be able to get a partial tax bankruptcy discharge for some of it—and set up a payment plan for the rest.
Chapter 7 Bankruptcy
Chapter 7 is often considered a “saving grace” for anyone in over their head with insolvency because it completely eliminates all dischargeable back tax debts. This strategy is used for those who are unable to pay back income tax debt; however, it is more difficult to get approved for than the other chapters of bankruptcy.
Can You File Chapter 7 Against the IRS?
One of the most common questions we get is “can you file chapter 7 against the IRS”, and the answer is often yes. To be able to discharge federal income tax debt, you must qualify based on the conditions mentioned above.
While you can file Chapter 7 for income tax debt, the same strategy will not work for payroll taxes. Additionally, rules on previously unfiled tax returns are not uniform and newer liabilities are unable to be resolved. A Chapter 7 bankruptcy cannot discharge tax liens recorded before filing.
Under this chapter, the debtor will receive an absolute right to discharge all of the debts that are included as part of the bankruptcy. However, taxpayers will not receive an absolute discharge for their tax debts. The following tax debts will not be discharged in a Chapter 7 bankruptcy:
- Tax debts for which no original returns were filed by the taxpayer
- Tax debts for which a return was filed within 2 years of the bankruptcy petition
- Tax debts based on returns that were fraudulently filed
- Tax balances that arose because a taxpayer was found to have willfully attempted to evade their tax responsibility
Other tax debts, including assessed penalties are dischargeable unless the event that gives rise to the penalty occurred within 3 years of the bankruptcy or relates to an underlying tax balance that is not dischargeable.
Chapter 7 is not the only way to handle bankruptcy and taxes with the IRS, so you should consider other chapters before filing.
Are State Taxes Dischargeable in Chapter 7?
Yes, state taxes are dischargeable in Chapter 7 bankruptcy, in certain circumstances. Generally speaking, state income tax discharge factors line-up with those used by the federal government. So, if you are able to discharge your federal income taxes with a Chapter 7 bankruptcy, you should be able to discharge state income taxes.
However, since these circumstances can vary state-by-state, especially when it comes to business taxes, you should speak with one of our tax professionals before moving forward to get the most up-to-date information.
If you cannot discharge your state income taxes with a Chapter 7 bankruptcy, a Chapter 13 bankruptcy may be more helpful. With a Chapter 13 bankruptcy, the taxes won’t go away, but they can be spread out over the course of three to five years to make paying them more manageable; we’ll cover more on Chapter 13 bankruptcy below.
Regardless of what chapter bankruptcy a debtor decides to file, the tax may still be collectible from the debtor’s pre-bankruptcy property if the IRS filed a Notice of Federal Tax Lien before the bankruptcy petition was filed. If the IRS did not file a lien before the bankruptcy petition was filed, the tax lien will generally be removed as a result of the bankruptcy.
If the IRS did not file a lien before the bankruptcy petition was filed, the tax lien will generally be removed as a result of the bankruptcy. Since Chapter 7 and Chapter 13 are the most common types of bankruptcy filings that affect individuals, it is important to understand what tax ramifications filing for bankruptcy will have on all of your liabilities, including your tax debts before you make the ultimate decision to file.
Chapter 11 Bankruptcy
Chapter 11 is available to any business or individual, even though it is primarily used by corporations. Unlike chapter 7, Chapter 11 will not completely absolve you of all of your IRS tax debts. This should be considered more of a reorganization plan where some debts will be repaid and others will be forgiven. The individual or business will have its entities reviewed by a bankruptcy trustee who will balance the competing interest of creditors and the IRS.
Chapter 12 Bankruptcy
This particular chapter only applies to fisherman and farmers who get behind on their taxes. These businesses are treated differently because they are usually the first to be affected by an economic downturn or natural disasters. Historically, farms and fisheries were smaller businesses who needed to be protected so that food production remained the stable during a crisis like the Dust Bowl. The requirements and process are almost identical to a Chapter 13 filing but with further leniencies and special conditions.
Chapter 13 Bankruptcy
Chapter 13 is also called a wage earners plan. It enables the individual with regular income to develop a plan to repay all parts of their debt. The debtor will create a payment plan in which they repay their creditors over a period of 3-5 years in the form of installments. If a debtor files a Chapter 13 bankruptcy and complies with the payment plan that is confirmed by the bankruptcy court, that debtor will receive broad discharge of all the debts that were included in that payment plan. There are certain tax debts that must be paid in full even if they are included in this type of repayment plan and they are as follows:
- Withholding taxes
- Tax debts where no original return was filed by the Taxpayer
- Tax debts that arise after a fraudulent return was filed
- Tax debts that arise because a debtor willfully attempted to evade payment
Lastly, there is an exception in a Chapter 13 bankruptcy that will allow the IRS to collect on balances due if they did not receive notice of the bankruptcy filing in time to file a claim to protect their interests.
How Does Bankruptcy Affect Tax Filing?
Filing your taxes after declaring bankruptcy will not impact how you file your 1040 form. This is because debts that have been discharged under a bankruptcy are excluded from your taxable income.
It is important to note that while bankruptcy expenses for individuals are not tax-deductible, businesses may be able to claim these expenses on their tax return.
That said, if you have filed bankruptcy, there will be an additional form to file when you do your taxes—IRS Form 1041. You will need to file this additional form because, when you file for bankruptcy, a trustee is appointed to handle your assets for debt payment, which then becomes part of an estate.
Who files Form 1041 on your behalf will depend on the type of bankruptcy you have filed for:
- Chapter 7: A third-party trustee will file Form 1041 for you.
- Chapter 11: You will act as your own trustee, meaning you will be responsible for filing Form 1041.
- Chapter 13: The trustee will file Form 1041 for you.
It is important to note that if you owe taxes when filing your latest return, you need to pay them. Otherwise, they will be considered new debt, which is technically not allowed when you file bankruptcy. Meaning, that it cannot be dismissed under your bankruptcy filing. That said, courts may choose to enforce this policy, or not.
Bankruptcy is Not the Only Way to Deal Tax Debt
The IRS also offers other means of tax debt resolution, and our tax professionals can help you weigh your options including:
- Offers in compromise
- Installment agreements
- Stair step agreement
- Currently not collectible status
What Is the IRS Fresh Start Program?
The IRS Fresh Start Program allows taxpayers to pay off their debt by making monthly payments for six years. This debt-repayment option allows you to avoid bankruptcy, as well as IRS penalties such as interest, additional fees, tax liens, and more.
Get Assistance with Filing for Bankruptcy
If you are planning on filing for bankruptcy as an individual or as a business to resolve your tax debt, don’t go in alone. Community Tax’s expert professionals are standing by to assist and guide you through the entire process. We can answer all of your questions like “what are the differences between the different types of bankruptcy?”, “can you file chapter 7 against the IRS?”, and “what are the best tax debt repayment options?”.
You should never file for bankruptcy without first consulting a tax professional. The CPAs at Community Tax can analyze your case and assess if bankruptcy is the best course of action before you file. Don’t wait for the IRS to start seizing your assets, call Community Tax today (800) 684-4792.
If you are planning on filing for bankruptcy as an individual or as a business to resolve your tax debt, don’t go in alone. Community Tax’s expert professionals are standing by to assist and guide you through the entire process. You should never file for bankruptcy without first consulting a tax professional. The CPAs at Community Tax can analyze your case and assess if bankruptcy is the best course of action before you file. Don’t wait for the IRS to start seizing your assets, call Community Tax today (800) 684-4792.