Can bankruptcy help when the creditor is none other than Uncle Sam? When it comes to tax debt, make that a definite “Yes, but…”. There are five conditions that must be met in order for income tax debt to be eligible for a discharge under bankruptcy:
1. The due date for that tax return is at least three years earlier than
the bankruptcy filing
2. The tax return itself was filed at least two years earlier than the
bankruptcy (If no tax return was filed at all, there’s no discharge
3. The tax assessment is at least 240 days old
4. The tax return isn’t fraudulent
5. The taxpayer isn’t guilty of intentional tax evasion
The immediate impact of filing bankruptcy, as I explained in “Oh, Yes, You Can Get Rid Of Back Taxes” is that, as soon as you file, an automatic stay goes into effect, stopping all collection efforts, including those of tax collectors. That means no property can be seized and no wages garnished.
What about back income taxes that don’t meet the five rules? In a Chapter 7 bankruptcy, the debtor’s debts are assigned priorities for payment. Most of the time, tax debts owed from before the bankruptcy petition is filed are classified as eighth priority. All the assets of the debtor, minus exemptions (property the debtor is allowed to keep), are called the “bankruptcy estate”.
The secured creditors are paid first out of that estate, and then on down the line of priority. If, and only if, there are enough assets left to pay the back taxes (the ones that don’t qualify for discharge), will those be paid out of the bankruptcy estate.
If there are taxes still owing, the debtor might remain liable for payment at the conclusion of the bankruptcy. At the very least, filing bankruptcy buys valuable time to work out a “plan of attack” for addressing tax and financial problems.
There are, of course, more “ins and outs” of both tax law and bankruptcy law than I can describe in a blog. As just one example of the complexities, Chapter 7 bankruptcy can be filed only once every six years, but the IRS can keep up its efforts to collect tax debt for ten years.
It’s not nice to fool the IRS, of course, and the penalties are severe for those who try. But even with the most honest of intentions, it’s wise to consult experienced legal counsel when it comes to making all the rules work in your favor.