Does Bankruptcy Clear Tax Debt?

There are two types of personal bankruptcies, which are a reorganization program under Chapter 13 and the discharge of debts under Chapter 7. A Chapter 13 bankruptcy lowers the amount of total debt you owe, and you agree to make court-supervised payments for three years to pay the reduced amount to creditors. This type of bankruptcy does nothing about tax debts.

The bankruptcy type that wipes out personal debts is filed under the rules of Chapter 7. Chapter 7 allows personal debt elimination such as using bankruptcy for credit card debt. Does bankruptcy clear tax debt? Unfortunately, Chapter 7 bankruptcy does not remove most tax debts or other federal obligations. The U.S. government wants to be paid!

I know you are hoping for help and worrying about does bankruptcy clear tax debt? There are some circumstances where some tax debts may be discharged in bankruptcy, which I will explain. There are additional steps for debt management that can be used to reduce or eliminate tax debts, which this guide will show you how to do.

I will also give you great advice on how to access resources and to evaluate those that offer to help with these problems.

For bankruptcy, you will need a qualified bankruptcy attorney to file the paperwork with the courts. For tax debt reduction or elimination, you need a tax attorney to help. It is critical that you select qualified attorneys who do not rip you off, so you need to learn how to conduct due diligence to select a good attorney.

Before choosing an attorney, do these things:

Check with the state authorities online to see if the attorney is licensed and in good standing
Check with the American Bar Association to see if the attorney has any complaints that are unresolved
Check for unresolved complaints with the Better Business Bureau

Relief from Harassment by Creditors

You will get immediate relief after you select and engage a bankruptcy attorney because you only need to inform creditors that you are represented by an attorney. After that, they can no longer call and harass you.

If creditors or collection agencies continue to call you after you tell them in writing that you have an attorney, your attorney can sue them for the violation. Once you get the help of a bankruptcy attorney, you will have such a sense of relief and that will allow you time to prepare for dealing with the tax debt problems calmly.

Non-Dischargeable Priority Debt

The bad news is there are many categories of debt that are not discharged in personal bankruptcy with tax debt being on the top of the list with the highest priority of needing to be paid. This means whatever assets you have left are sold, if any, after a bankruptcy, are used for the tax debts. The taxes are paid off before any other creditors. Any amount of non-dischargeable tax debt that is not paid out of the bankruptcy remains your obligation to pay.

Other non-dischargeable debts include student loans, child support, spousal support, and other legal obligations to pay familial support, such as money owed due to a divorce settlement.

A bankruptcy does not discharge debts that are not listed in the bankruptcy filing so be sure to include everything. Other debts for luxury goods that were bought during the 90 days before a bankruptcy and cash advances have taken during 70 days before the bankruptcy are not discharged either.

Any governmental fines or penalties are not discharged by bankruptcy and this includes state taxes, interest, and penalties on taxes owed.

Does the IRS or Any State Ever Lose the Right to Collect Tax Debt?

The statute of limitation for federal tax debt is ten years from the date of the assessment. This ten-year period is extended if any payment is made on the debt, or if the IRS is successful in collecting anything such as through garnishment of wages.

The state rules for the collection of state taxes range from three to 15 years, so you have to check with the regulations in your state to find out how long they will try to collect unpaid state taxes.

What to Look Forward to in Spite of Bankruptcy Troubles

If you are already in the financial hell of having to go bankrupt, having the additional problem of dealing with tax debts can feel overwhelming. I want to encourage you to take a deep breath and learn more about what can be done. After you deal with all this trouble, you will want to use Goalry Mall online tools to manage your budget, credit, loans, and build wealth so you never have to be under this stress ever again.

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Your Bankruptcy is Underway, So What About Tax Debt?

It takes some time to reduce or eliminate tax debts too; however, is worth the effort so that you get the best chance to start over. The good news is that if you are totally wiped out financially, you are in an excellent condition to eliminate tax debts by taking the extra steps with the IRS and state taxation systems. You can do this after your bankruptcy is finalized.

The rules about what federal tax debt can be eliminated through bankruptcy are very specific, which are:

Tax Debt Must Be Old: The federal tax return for the tax debt you want to discharge in bankruptcy was due (including any time granted for tax-filing extensions) at least three years before the filing date of your bankruptcy.
Tax Return Was Filed: For the taxes due, you filed a tax return at least two years before your bankruptcy filing date. If you filed a late tax return, some legal jurisdictions will not discharge the tax debt, so check with your bankruptcy attorney.
Tax Debt Assessment by the IRS: The IRS has not yet determined (assessed) the amount of your tax debt or the assessment was made at least 240 days before the date of the bankruptcy filing.
No Tax Fraud Allowed: Your tax rerun was not willfully fraudulent, and you did not engage in willful tax evasion.

The dates are important so if you have older tax debts be sure to discuss this with your bankruptcy attorney. You may need to slightly delay your bankruptcy filing date if you are close to the necessary time limits for older tax debts.

The Trouble With Tax Liens

Getting old tax debts discharged in bankruptcy prevents the IRS from garnishing your wages to pay off the tax bills. However, tax liens are a different story.

Even if older tax debts are discharged in bankruptcy proceedings if the IRS already placed a tax lien on your property you are out of luck. That tax lien remains in place and must be paid off if the property is ever sold. Discuss this with your bankruptcy attorney because if the property is not your personal residence you may be forced to sell it in the bankruptcy proceedings.

Escaping Federal Tax Debt

Now that I have you completely depressed over the fact that you will be stuck with tax debt for the rest of your life, there are some ways out!

Get a Fresh Start

One is the Fresh Start Program that allows a person to settle an IRS tax debt for less than the amount owed. One benefit of the Fresh Start Program is that the IRS usually does not issue a tax lien if the tax debt is less than $10,000.

If the tax debt is $50,000 or less, the IRS allows monthly installment payments over 72 months (six years)

Here are the Fresh Start Program qualifications:

Married couples need to earn less than $200,000 and individuals need to earn less than $100,000 annually
You must be unemployed for at least 30 consecutive days
Only one person of a married couple, who files taxes jointly, needs to qualify
The taxes due are less than $50,000
Self-employed people must show a minimum decrease of 25% in net income

Offer in Compromise

There is another program that allows one-time tax forgiveness with the IRS and many state tax authorities also. It is called making an “offer in compromise.”

Here are the pre-qualifications you need to pass before making an offer in compromise to the IRS:

You cannot be in bankruptcy proceedings, so you have to wait until the bankruptcy is finalized
You must file all tax returns you are legally required to file
You must have received a bill for at least one tax debt to make an offer to resolve the debt
You must make all required estimated tax payments for the current year
If you own a business with employees, you must make all required federal tax deposits for the current quarter
You cannot have been turned down for an offer in compromise before

Here is how an offer in compromise works:

About 40% of the requested offers in compromise are accepted by the IRS. That also means that 60% are denied.
Qualifying depends on the certainty of the tax liability (if the amount is in dispute), the ability of the IRS to collect the tax debt (based on your ability to pay and assets you own) and if paying the tax debt creates a financial hardship for you.

If your bankruptcy is finalized, and you still owe the IRS, this is the time you can expect to make an offer in compromise that will succeed. Do not be fooled by the ads on television that say the entire debt will be wiped out. An offer in compromise should include some money with the offer. However, if you just went bankrupt with no assets remaining in your possession, the percentage of the amount you offer can be very low.

The IRS Calculation

The way the IRS calculates the validity of an offer in compromise is it must be at least the value of your assets and any anticipated future income, less living expenses. If you end up with no assets after bankruptcy and are not employed, you are in the best position to offer a very small amount to the IRS, even the $1 minimum (you cannot offer zero).

You have to pay for the filing of an offer in compromise, which is around $200, and give 20% of your offer when you file it, as a deposit, if offering a one-time payment. You have the option to make payments for six to 24 months.

If you chose to make monthly payments, you need to include the first payment with the offer and continue to make your proposed monthly payments while the IRS considers your offer. Any money you pay is applied to reduce your tax bill.

Low-income applicants can get an exception from the IRS and do not have to include an initial payment or make monthly payments while the IRS considers their offer. Be aware the IRS is overwhelmed with work right now due to the pandemic so the approval process for an offer in compromise may take a very long time.

To make an offer in compromise you want to work with a tax attorney that specializes in this procedure. Be sure the attorney you choose is qualified and the fees charged are reasonable and fully explained to you.

If the offer in compromise is not acceptable to the IRS, you are allowed to modify the amount to a higher amount that is acceptable.

Offer in Compromise for State and Local Taxes

Many state and local tax authorities have an offer in compromise program that is similar to the one offered by the IRS. Check with the regulations in your state and municipality because the rules are different in each area.

Winning the Lotto

If you win the lotto be aware that first, they will withhold a portion of the winnings to pay the taxes on the prize amount. Then, they will withhold all your outstanding tax debt.

You might think you will not care about this if you win the lotto. However, this same thing happens if you win a small prize not just for winning millions. Some people who win a smaller prize of a few thousand dollars are surprised that they do not get any of the money if they owe tax debt.

The federal government is informed if you win because the state’s lotto department withholds the taxes for the federal government. Moreover, most states allow garnishment of lotto winnings for any taxes or other debts that are owed to the state and other non-dischargeable debts, such as child support.

Conclusion

A bankruptcy does not get rid of tax debts. However, bankruptcy does give you the opportunity to apply to the IRS Fresh Start Program or make an offer in compromise to the IRS to reduce or eliminate your tax liability. Be sure to work with competent legal counsel for your bankruptcy and when making an offer in compromise.