Does Bankruptcy Cover Back Taxes?

Not all debts are created equal, especially when it comes to bankruptcy. While Chapter 7 and Chapter 13 both allow debtors to greatly reduce or wipe out many of their debts, some liabilities are difficult if not impossible to escape. So which category does tax fall into? Does bankruptcy eliminate tax debt, or not? In short: it depends.

Whether or not your taxes are dischargeable will depend on when they were initially due, whether you file a timely return, and when the IRS assessed your returns. It should also be noted that you might also be able to discharge the interest and penalties that accrue. While this might sound complicated, our Berks County bankruptcy lawyers explain how it works in more detail below.

When someone is overwhelmed by debt, even tax debt, filing for bankruptcy can provide relief. In some cases, you might be able to eliminate old tax debt. In others, it is more manageable to pay back your tax debt through bankruptcy. To discuss your available options, call Young, Marr & Associates at (215) 701-6519 in Pennsylvania and (609) 755-3115 if you live in New Jersey.

Does Bankruptcy Erase Tax Liability?

Debts which can be eliminated are known as dischargeable debts, because they are wiped out once the bankruptcy case is finalized or “discharged” by the court.  Discharge is always the goal in bankruptcy.  If a case is dismissed, it means the court found a problem, and the result is that the debtor is still liable for their debts and can still be pursued for repayment by creditors.

Most debts are dischargeable under both forms of bankruptcy, including but not limited to the following:

It’s a long list, but you may have noticed something missing: back taxes.

That’s because – generally speaking – back taxes are considered nondischargeable.  Other debts bankruptcy doesn’t erase include alimony, child support, and student loans.

While taxes can potentially be discharged, wiping out tax debt can be difficult because there are several factors which must be in place.

Moreover, there are certain types of tax liabilities which simply cannot be eliminated, regardless of the debtor’s financial circumstances.  For example, it is impossible to discharge payroll tax, or tax to which employers and employees are subject.  Payroll tax can either come directly out of an employee’s wages or salary, or the employer can pay tax based on how much money the employee makes.  If you have any uncertainty at all about your payroll tax liability, you should consult with a CPA and/or an attorney who handles tax matters.  Otherwise, you might find yourself being targeted for an audit by the IRS (Internal Revenue Service).

When Are Tax Debts Dischargeable in Chapter 7 or Chapter 13?

Getting back to tax debts which can be erased, it is critical for debtors to understand the four main criteria which must be in place.  Three out of four of these criteria hinge on strict time limits.

First and foremost, the tax liability absolutely must not involve any element whatsoever of fraud.  The IRS defines fraud as “deception by misrepresentation of material facts, or silence when good faith [transparency] requires expression, which results in material damage to one who relies on it and has the right to rely on it.”  In simpler terms: causing financial harm by lying about money.  Tax fraud occurs when (1) a taxpayer owes a tax, and (2) has “fraudulent intent” (intent to commit fraud).

Next, you must have filed a tax return – even if you didn’t pay what you may have owed – at least two years before the date you filed (or plan to file) for bankruptcy.  Failure to file and failure to pay are separate matters, and the IRS is generally more concerned with failure to file.

Furthermore, the tax needs to be old, dating back at least three years.  Therefore, back taxes you owe from this year or last year would be not be considered dischargeable.  The three-year period starts counting backward from the date you filed for bankruptcy, so if you filed on January 1, 2021, the tax would need to originate from a date earlier than January 1, 2019.

Not only does a debt need to be at least three years old, it also needs to pass what’s called the 240-day rule.  As you might have guessed, this rule takes its name from a 240 day period, or about eight months.  Think of the date you filed for bankruptcy (or intend to file for bankruptcy), and then consider the following statements:

  • The income tax was assessed (meaning that its value was determined) at least 240 days before your filing date.
  • The tax has not been assessed yet.

If either of those statements is true, the tax is potentially dischargeable (provided all other criteria are met).  If not, you are probably stuck with your tax liability.

Taxes in a Chapter 13 Bankruptcy

As seen above, delinquent taxes must meet several requirements for them to be dischargeable. However, if you have a delinquent tax obligation, you could still benefit from filing a Chapter 13 case. Typically, any portion of the tax debt that fails to meet the requirements discussed above will have to be paid back through the Chapter 13 plan. However, not all taxes are treated the same.

Income Tax

If you owe back income tax, the first step is determining if the debt is categorized as priority or nonpriority. If your back taxes are classified as a priority debt, they must be paid in full. However, nonpriority tax debt is considered unsecured and could be discharged or will only be partially paid based on your discretionary income.

Priority vs. Nonpriority Debt

To be considered nonpriority, your tax debt must meet all of the following criteria.

  • The tax debt is based on income or gross receipts.
  • The income taxes were due at least three years, including extensions, before you filed your Chapter 13 case.
  • Your tax return was filed at least two years before the filing date of your bankruptcy petition. However, if your return was filed late or if the IRS filed a substitute return on your behalf, a number of bankruptcy courts have held that the taxes will remain a priority debt.
  • Your taxes were assessed at least 240 days before your bankruptcy was filed.
  • You did not willfully avoid paying your taxes or commit fraud.

If your taxes fail to meet any of the above requirements, they will be considered a priority debt.

Interest on Tax Debt

If you owe back taxes, you know you owe more than the initial tax debt – you also owe interest and penalties. The Bankruptcy Code treats interest and penalties differently.

A debtor can discharge interest if the associated taxes are dischargeable. Therefore, if your taxes meet the requirements above and are considered nonpriority, both the taxes and interest are dischargeable.

Penalties

Penalties are different from interest or the underlying taxes. The penalties you have incurred due to your failure to pay your tax obligations only must comply with the three-year rule. Therefore, you could still owe both the outstanding taxes and interest but still be able to discharge the associated penalties.

If the underlying tax is three years old, the penalties are treated as an unsecured debt. This means that they will be discharged if you filed Chapter 7 and paid last, if at all, if you filed a Chapter 13 case. If you are above the median, your disposable income will determine what percentage of penalties are paid. For debtors below median, perhaps filing Chapter 13 to pay back taxes, the penalties will be eliminated.

The Automatic Stay and the IRS

If you ask any bankruptcy lawyer, they will tell you bankruptcy’s automatic stay is one of the most powerful tools a debtor has. This injunction stops all creditors from taking any actions against the debtor. While many people consider the IRS an omnipotent beast, it still must adhere to the parameters set by the stay. Yes, even the Internal Revenue Service is barred from trying to collect on its debt while you are under bankruptcy protection.

However, the IRS is granted some leeway under the Bankruptcy Code. For example, the IRS is permitted to continue assessing interest and penalties until you receive a discharge in a Chapter 7 case or complete all the requirements under your Chapter 13 plan. While your case is pending, the IRS is not allowed to try and collect any debt owed. If you receive a discharge or successfully complete your Chapter 13 case, the IRS will abate any fees that accrued during your bankruptcy case.

Other Tax Requirements in Bankruptcy

A bankruptcy petitioner has more to worry about more than discharging or paying back their taxes through bankruptcy. To be eligible for a bankruptcy discharge, a filer must prove that their previous four years of tax returns were filed. If, for some reason, the required tax returns were not filed before the case was filed, they must be filed by the date of the debtor’s first 341 meeting. The debtor could also provide an affidavit indicating that they were not required to file taxes. Additionally, the debtor must provide the trustee a copy of their most recent returns before the scheduled 341 meeting. The trustee will file a motion to dismiss the case if the debtor fails to comply with these requirements.

The Benefit of Filing for Bankruptcy if You Have Unpaid Back Taxes

If you are in a position to discharge old tax debt, filing for bankruptcy makes complete sense. However, even if you have to pay your taxes back, bankruptcy still might be a better option than dealing directly with the IRS.

If you enter into an agreement with the IRS, it will likely continue to assess interest and penalties on the outstanding debt. This means you will pay significantly more than the original tax debt. In many cases, the monthly bill to the IRS will impact your ability to pay your other monthly expenses, including your utilities, rent, or mortgage. Not only that, dealing with the IRS can be frustrating and a single mistake could cost you more money.

However, paying your back taxes through Chapter 13 offers many benefits. First is the automatic stay, which will stop any garnishments on your wages or freezes on your bank account. This only can make paying the back taxes and your other bills more manageable. And while interest and penalties will accrue while the bankruptcy progresses, these extra charges will not be included in your bankruptcy payment. Additionally, these charges will be eliminated once you successfully complete your case.

A Chapter 13 bankruptcy lasts five years. This is generally more time than the IRS would grant you to pay back your outstanding taxes. Therefore, your monthly payment will be substantially lower. Additionally, some of the penalties that have been assessed could be discharged as unsecured debt – lowering your payment. If you have outstanding taxes, contact our Pennsylvania bankruptcy lawyers to discuss your options.

Our Philadelphia Bankruptcy Lawyers Will Help You Understand Bankruptcy and Taxes

If you’re struggling with tax debt or other types of debt, bankruptcy may be able to give you a clean financial slate so that you can start repairing your credit.  To discuss whether filing for Chapter 7 or Chapter 13 could be a good option for you, call the Philadelphia bankruptcy attorneys of Young, Marr & Associates at (609) 755-3115 in New Jersey or (215) 701-6519 in Pennsylvania.  Your first consultation is completely free of charge, and we will keep your information confidential. We have more than two decades of experience and represent clients throughout New Jersey and Pennsylvania.