The most common of all of debts owed to the IRS is unpaid income taxes, also known as back taxes. Chapter 7 bankruptcy is an option if your tax debt meets certain requirements.
Written by Attorney Jonathan Petts.
Updated October 1, 2021
Debts owed to the IRS come in many shapes and sizes. The most common type of debt people owe to the IRS is back taxes, also known as unpaid income taxes. Now that more people freelance full time or moonlight part time, back taxes are a bigger issue than ever.
Looming unpaid debt can be stressful, and the IRS can be aggressive in its efforts to collect back taxes. As a public entity, the IRS is the world’s largest debt collector, and it has many tools that private debt collectors can only dream of. Fortunately, filing Chapter 7 bankruptcy is a straightforward way to stop IRS harassment. 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. Each is slightly more threatening than the last. Eventually, these letters become legal notices. They also sometimes involve filing a lien, seizing a bank account, or garnishing wages. The automatic stay acts as a pause button. It 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 can't 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 and other debt collectors can't touch any of the more valuable assets you happen to own.
An automatic stay is a powerful tool for protecting individuals. No matter what stage IRS collection efforts are in, the automatic stay stops them cold. With few exceptions, the stay applies to all forms of communication between debtors and creditors. Creditors who violate the stay can face serious consequences. And, although the stay prevents creditors from contacting you, it does not prevent you from beginning conversations with them. This puts you in control of negotiations with your creditors during bankruptcy.
Tax Debt Discharge in 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 tax debt as priority unsecured debt in Part 1 of Schedule E/F.
Trustee meeting: At this meeting, the trustee will review your paperwork, confirm your identity, and ask questions about any red flags in the paperwork.
In special circumstances, you'll have to meet additional qualifications to discharge some types of debt. This may be true in cases involving tax liens. It's also true in student loan cases. If you want to discharge student loan debt, you must convince the court that there is an undue hardship preventing you from repaying 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 and that the IRS will object to discharge if it has any reason to do so.
Chapter 7 bankruptcy only discharges income tax debt. Beyond that, the space is not very well defined. 1040 taxes are definitely income taxes. But property taxes and trust fund taxes are definitely not income taxes. To ensure that Chapter 7 can erase your debts, you'll need to know what kind of taxes you owe.
You must have filed your tax returns for the past two years if you're required to file. Your tax returns for the debt you want to discharge must have been on file for at least two years at the time you file for bankruptcy. 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.
The income tax debt must be at least three years old. Note that Tax Day is not always April 15. Some years, it's April 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'll have to start over.
Your tax assessment can't be more than eight 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 is done internally. But generally, if the taxpayer has not received a bill that breaks down the amount due by tax years, the IRS has probably 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 country 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 on 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 IRS usually backs off once the taxpayer starts an installment agreement. After all, the IRS just wants the money. It doesn't really want to garnish your wages. Keep in mind that 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 many programs to help taxpayers pay their tax debt when they have little or no money. The main example is the Offer in Compromise program where taxpayers pay what they can, and the IRS forgives the rest. This program can be extremely complex, and few people qualify. Also, if the taxpayer has any assets whatsoever the IRS will force the taxpayer to sell them. Finally, while the taxpayer negotiates, the IRS’s harassing collections techniques continue.
File for bankruptcy. Some people file for bankruptcy to take advantage of the automatic stay. That’s especially true if the IRS is already threatening to garnish your wages or levy your bank account. The big drawback here is that you'll have to wait eight years before you can receive another Chapter 7 discharge. While filing bankruptcy before you’re eligible to discharge your tax debt may bring immediate relief, it also 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 for 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.
Owing past-due income taxes can be stressful. These bills are often so high that, even if you fall behind a little, you could end up owing a lot of money. Fortunately, if your debts meet certain requirements, filing Chapter 7 bankruptcy can erase past-due income tax debt in one fell swoop.