When you’ve fallen into financial hardships, filing for bankruptcy can offer a much-needed lifeline, helping you to get back on track again. But does bankruptcy clear tax debt? Most types of tax debt are not dischargeable in bankruptcy cases, meaning that you will still be liable to pay the IRS what you owe them.
Income tax debt will likely follow you around unless you can prove that your federal income taxes will cause undue and severe hardship or that the tax debt is a result of a mistake. In these instances, you may be able to appeal the tax debt during your bankruptcy filing. If the IRS has a federal tax lien attached to your property, the chances of discharging IRS tax debts will be slimmer.
Types of bankruptcy and how they affect tax debt
There are two types of bankruptcy filings available to taxpayers in the U.S., namely, Chapter 7 and Chapter 13. There are slight differences between these filings and how tax debt is handled.
Chapter 7 bankruptcy
The biggest benefit from a Chapter 7 filing is that you can erase dischargeable debt within 4–6 months without repaying creditors. However, you will remain liable for your taxes after your case ends. This type of bankruptcy clears credit card debt, medical bills, past-due rent payments, payday loans, overdue utility bills, and even car and mortgage loans.
In order to assess your eligibility for a Chapter 7 filing, you will need to complete a means test. This test will lean heavily on your income to determine if you qualify for bankruptcy. Depending on the outcome of your case, you may also not be able to keep your assets unless they qualify as exempt assets.
With Chapter 7, you can benefit from the sale of your property because the proceeds of the sale will go to offset priority debt, which includes state income tax debt.
Chapter 13 bankruptcy
With a Chapter 13 bankruptcy filing, you pay a discretionary income to your creditors over a 3-5 year period. This option is available to filers who did not qualify for Chapter 7 bankruptcy due to being a high-income earner. Filing bankruptcy under Chapter 13 will allow you to keep your assets and rebuild your credit score much faster than a Chapter 7 filing.
Some tax debt may be dischargeable, but it is more likely you will repay your tax debt as part of the 3-5 year repayment plan.
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The best way to avoid bankruptcy and outstanding tax debt is by careful planning of your finances and tax obligations. Tax planning services are essential if you’re a high-income earner or business owner. In the event of a financial disaster, the strategies you put in place now will help you navigate through the deep waters of an economic downturn or a personal crisis. Call Hall Accounting Company today to discuss your situation with our tax associates.
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How will bankruptcy affect future filings?
Filing for bankruptcy will not affect your future tax filings. You are required to complete a tax return regardless of where you are in the bankruptcy process. If the IRS owes you a tax refund when you file for bankruptcy, you may be able to protect it with a bankruptcy exemption under a Chapter 7 filing.
The bankruptcy court will likely inspect any tax refunds, current income tax returns, and any property taxes to ensure you are complying with filing taxes while your bankruptcy case continues. Any attempt at willful evasion or noncompliance with bankruptcy law will negatively impact the outcomes of your case. It is important to share all financial information with your bankruptcy trustee so that you can meet your tax obligations.
How to manage tax debt with Chapter 7 bankruptcy
We have previously discussed that tax relief can be achieved in certain instances, such as evidence that you will be under extreme economic hardship or mistakes on your return that resulted in unpaid taxes. Below are several stipulations that will guide you as to whether you will qualify to discharge tax debt.
The debt is income tax owed to the Internal Revenue Service.
The overdue taxes have been outstanding for at least three years.
You did not commit willful fraud or dishonesty when submitting your tax return.
You filed a tax return for the outstanding tax debt at least two years before the bankruptcy filing.
The IRS must have assessed your tax return at least 240 days before the bankruptcy filing.
A Chapter 7 filing will not eliminate payroll taxes or tax penalties related to a fraudulent tax return.
How to manage tax debt with Chapter 13 bankruptcy
This type of bankruptcy is more a reorganization of debt over the period of 3–5 years, as we have previously mentioned. However, there are some provisions for obtaining tax relief.
Tax debt older than 3 years may be forgiven under certain circumstances. This should be discussed with an experienced bankruptcy attorney.
Discharged tax debt won’t incur any additional interest or penalties.
IRS tax liens can be satisfied under a Chapter 13 filing
The IRS is subject to the repayment plan, provided all your current tax obligations are being handled correctly.
Alternatives to bankruptcy for managing tax debt
In this section, we cast our attention on alternatives to bankruptcy for managing tax debt. If you haven’t yet made up your mind about whether you should file bankruptcy, then this is a good time to take stock and avoid the process if at all possible.
Be proactive
Bankruptcy can be due to a once in a lifetime financial crisis, but mostly it creeps up on people over a number of years. You take small knocks, overspend on your credit cards, accrue medical bills during a long illness, lose your main income, or become unemployed. Being proactive involves noticing the warning signs while you can still make changes and do something about the situation.
Working with an accounting and taxation firm (especially if you own a business) can help you steer your finances in the right direction before it gets out of control. By looking at the bigger picture and putting proactive tax planning strategies in place, you will be empowered to correct any financial difficulties and manage how you settle your tax debt. Doing this will help you avoid a bankruptcy filing and put you in a stronger financial position for the future.
Consult with the IRS for financial assistance
The IRS is not as eager as some think to force taxpayers into bankruptcy. The reason for this is that it doesn’t benefit the federal government to enter into a process with you where there is a chance you may have your tax debt discharged. They would rather help you deal with your tax debt through one of their assistance programs.
1. Offer in compromise (OIC)
An offer in compromise helps you to settle your tax debt for less than you owe the IRS. This is a legitimate option when you can’t pay your full tax liability, and doing so will create significant hardship. The factors they will consider are:
Ability to pay (level of income earned)
Assets
Expenses
Eligibility will depend on whether you filed your return on time. You should also not be in an open bankruptcy proceeding.
2. Installment agreements
If you’re a regular taxpayer and have diligently completed your tax returns on time, you may qualify for a payment plan with the IRS. Each case is evaluated on its own merit, and you are provided with feedback on the suggested payment terms. Likely, you will still accrue some interest and penalties, but there are times when the IRS will waive additional penalties for prompt payment.
3. Temporary delay in payments
If the IRS determines you can legitimately not pay off your tax debt, your account will be marked as ‘currently not collectible,’ and collection of outstanding debt will be temporarily halted until your financial situation improves. However, the debt does not go away. It is merely put on hold until you can pay it. You will need to report any changes to your financial situation to the IRS so that they can review your case.
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Need help approaching the IRS? Hall Accounting Company’s highly skilled tax associates have experience with IRS financial assistance programs and will submit your application with all the necessary documents. Call now.
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Final thoughts
Bankruptcy can be a long and stressful process at best, and if there is any way to avoid it, you should look at those options. The most effective way of ensuring you never have to file for bankruptcy is to proactively engage in professional financial planning services such as those offered by Hall Accounting Company.
By putting effective money management strategies in place, you can plan for different emergency scenarios. Professionals actively working with your finances will help you avoid financial pitfalls that can get you into a tight spot with creditors and the IRS. If you do fall on hard economic times, you will have the comfort of knowing that you have an expert representing your case with the IRS. This is beneficial because the IRS is more likely to accommodate you if you’ve been handling your tax affairs responsibly.
If you have no other option left than to file for bankruptcy, a bankruptcy attorney will help you decide what type of bankruptcy to file, giving you the best chance of retaining your assets and moving speedily to rehabilitating your financial credit record.
Thank you for your time while we discussed whether bankruptcy eliminates tax debt. If you would like to discuss your options, the team at Hall Accounting Company is waiting to help you.