The most common of all of debts owed to the IRS is back, or unpaid, income taxes. Chapter 7 bankruptcy is an option if your tax debt meets certain requirements.
Written by Attorney Jonathan Petts.
Updated January 5, 2021
Debts owed to the IRS come in many shapes and sizes. The most common of all of debts owed to the IRS is back, or unpaid, income taxes. Now that more people freelance full time or moonlight part time, back taxes are a bigger issue than ever.
Even if a debtor only owes a few thousand dollars, that debt could feel like a few million dollars. Additionally, the IRS can be aggressive when it comes to back tax collection. As a public entity, the world’s largest debt collector has a number of tools that private debt collectors only dream of. Fortunately, Chapter 7 is a straightforward way to end IRS harassment like this. In many cases, as outlined below, bankruptcy might end IRS harassment for good.
Tax Debt: Bankruptcy and the Automatic Stay
Most IRS collections start with a notice of past-due taxes. Then, every few months, the IRS sends another letter which was slightly more threatening than the last one. Eventually, these threatening letters become legal notices which sometimes involve filing a lien, seizing a bank account, or garnishing wages. The automatic stay acts as a “pause” button and prevents creditors from contacting you to collect their debts.
As soon as you file your voluntary petition, the automatic stay usually takes effect. When that happens, IRS agents cannot even send you a letter about your back taxes. They are forbidden from trying to collect the debt.
The automatic stay extends to property as well. Although, most of your personal property is “exempt,” -- or protected -- during Chapter 7, the IRS, or any other debt collector, cannot touch your more valuable assets if you happen to own them.
No matter what stage the IRS collection effort is in, the automatic stay stops it cold. Outside of the few exceptions, the stay applies to all forms of communication between debtors and creditors. Creditors who violate the stay can face serious consequences.
The automatic stay is a powerful tool for protecting individuals. And, although the Stay prevents creditors from contacting you, it does not prevent you from beginning conversations with their creditors. So, if you negotiate with your creditors during bankruptcy, you are in control.
Tax Debt Discharge in a Chapter 7: A Timeline
All these rules apply to the bankruptcy process as well. If you have past due tax debt, things will be a little different.
Filing: On your paperwork, you will list the debt as priority unsecured debt in Part 1 of Schedule E/F.
Trustee Meeting: At the 341, the trustee reviews the debtor’s paperwork, confirms the debtor’s identity, and asks questions about any red flags in the petition or schedules.
Discharge: The court has the power to discharge both secured and unsecured debts. If your debts meet the requirements above, you should receive a notification of a discharge within about 60 days.
In special circumstances, the debtor must meet additional qualifications to discharge some types of debt. This is sometimes true in cases involving tax liens, and it’s also true in student loan cases. These debtors must convince the court that an “undue hardship” prevents them from paying the loan.
What Determines Whether Your Taxes Can Be Erased?
The IRS is very big on rules. There is a regulation for pretty much everything. So, it should be no surprise that there are specific rules for bankruptcy discharge. It should also be no surprise that the IRS will object to discharge if it has any reason to do so. The primary bankruptcy discharge rules all pertain to time.
Income Taxes. Chapter 7 bankruptcy only discharges income tax debt. Beyond that, the space is not very well defined. 1040 taxes are definitely income taxes. However, property taxes and trust fund taxes are definitely not income taxes. Be sure to check what kind of taxes you owe in order to be sure that Chapter 7 can erase your debts.
Must have filed returns for the past two years (if required to file). The taxpayer’s returns must have been on file for at least two years at the time of bankruptcy filing. The two-year waiting period applies even if the returns were filed on time. If the taxpayer fails to file, the IRS often prepares substitute returns and uses them to calculate the taxpayer’s arrearage. Substitute returns do not count as taxpayer-filed returns.
Tax debt must be at least 3 years old. The income tax debt must be at least three years old. Note that Tax Day is not always April 15. Some years, it could be the 16th, 17th, or even 18th. IRS lawyers have been known to object to discharge over one or two days. So, make sure you file the petition on the correct day, or else you will have to start over.
Your tax assessment is no more than 8 months old. If the IRS has not assessed the debt within the last 240 days, the income tax debt is not dischargeable. It’s almost impossible to tell if the IRS has assessed the debt or not, because this process is an internal accounting tool. But generally, if the taxpayer has not received a bill which breaks down the amount due by tax years, the Service probably has not assessed the debt.
Special Rules for Student Loans
Special rules apply to other types of government debt as well. For example, student loan debt isn’t usually dischargeable during Chapter 7. Debtors must usually show undue hardship to discharge their education debt. “Undue hardship” means different things in different parts of the county, because the Supreme Court has not ruled on this issue.
What Happens If I Have Tax Debt that Can’t Be Erased Yet?
Plenty of taxpayers are in this boat, and they all have several legal options. An attorney can advise you as to the best course of action, but ultimately, the decision is yours.
Pay in installments. Some people talk to the IRS about a payment plan. The Service usually backs off once the taxpayer starts an installment agreement. After all, the IRS just wants the money. The agency does not really want to garnish your wages.
However, installment agreements are only a good idea if you have the money. If that’s not the case, you need another option.
Participate in the “Offer in Compromise Program. The IRS has a number of programs geared toward taxpayers with little or no money. The main example is the Offer in Compromise program. In this program, taxpayers pay what they can and the IRS forgives the rest.
This program can be extremely complex, and only a few people qualify. Furthermore, if the taxpayer has any assets whatsoever, even a family heirloom quilt, the IRS will force the taxpayer to sell it. Finally, while the taxpayer negotiates with the IRS, the Service’s harassing collections techniques continue.
File for bankruptcy. Some people file bankruptcy to take advantage of the automatic stay. That’s especially true if the IRS is already threatening to garnish wages, levy bank accounts, or do other nasty things.
The big drawback here is the eight-year waiting period before the debtor can receive another Chapter 7 discharge. So, filing bankruptcy before you’re eligible to discharge tax debt gives immediate relief and creates a long-term headache. So, waiting until you are eligible might be the best approach. That’s especially true if you only need to wait a few months.
What About My Tax Refund?
This question comes up quite a bit. If you anticipate a large refund, talk about this issue with your attorney. It may be a good idea to delay filing until after you receive your tax year refund for the past year.
Technically, when consumers file bankruptcy, all their non-exempt property goes to the trustee. That includes tax refunds. Since the policies vary depending on where you live, you may be able to use the wildcard exemption to exempt the tax return.
As more people moonlight and freelance full time, past-due income taxes may become more of an issue. These bills are so high that, even if you fall behind a little, you could end up owing a lot of money. Fortunately, if your debts fall within certain requirements, Chapter 7 can erase past-due income tax debt in one fell swoop.