According to the Internal Revenue Service, you can eliminate your burden from past-due federal tax debt that you can no longer pay through filing for bankruptcy. With that said, bankruptcy under Chapter 13 or 7 of the United States Code is available for individuals who are facing extreme financial struggle — whether it’s because of losing a job, severe illness, serious injury, and/or a total change in their lives.
As such, in any situation where your income no longer satisfies your expenses and is subject to other qualifying criteria, bankruptcy may be a solid choice to start anew. Like most other forms of debt — such as unsecured loans, credit cards, and more — this option may open a door to let you escape from the challenges you’re facing because of unpaid taxes.
To walk you through different types of a bankruptcy filing, read on and discover the things you must do to clear your tax debt by declaring bankruptcy.
Types of Bankruptcy Filings
You’re sitting on your living room’s couch, looking at your bills and wondering how you’re going to make ends meet with all the collection notices. Having piles of debt that reaches an overwhelming amount is such a huge financial problem, especially when you just lost your job or your business is not doing well.
With all these, you might end up considering filing for bankruptcy, which is the last thing you want to do the time you have started your company and purchased your properties. Sometimes, you can be in a situation where it seems so hopeless and bankruptcy looks like the only answer. As such, it is crucial to know the different types of bankruptcy and which among them is a good fit for your current circumstances.
That said, here are the basic types of bankruptcy that may help you clear tax debt:
- Chapter 7. This Chapter is also known as liquidation and is the most commonly filed option by individuals and businesses with few or no assets. Chapter 7 allows them to dispose of their unsecured debts, such as medical bills and credit card balances. Moreover, an individual who files for Chapter 7 bankruptcy is basically selling off their properties and assets to clear all the money they owe to different creditors.
- Chapter 13. When an individual makes too much money to qualify for Chapter 7 may file Chapter 13 instead. This type of bankruptcy allows a person and business — that makes consistent income — to create a repayment plan to pay off their debts through installment.
- Chapter 11. The goal of business owners who file Chapter 11 bankruptcy is to reorganize their company and become profitable again. As such, filing for this type of bankruptcy lets businesses create strategic plans for profitability, cut costs, and find a new approach to increase income.
- Chapter 12. This type of bankruptcy provides relief to fisheries and farming. An individual who makes money through fishing and farming is allowed to maintain their business while working out a strategy to pay off their debts.
What Conditions Should Be Met to Discharge Tax Debt?
Do you want to discharge your tax debts? If you do, filing for Chapter 7 bankruptcy will be your best option. But you should make sure that the tax debt will be qualified for discharge, making you eligible to file for Chapter 7. With that said, here are the conditions you must meet in order to discharge your tax debt through Chapter 7 bankruptcy:
- Your tax debts are income taxes. To discharge your tax debt, these taxes must be from your income. Other than your income taxes, such as fraud penalties and payroll taxes can never be wiped out in bankruptcy.
- The debt is at least three years old. To discharge tax debt, your tax return must have been originally due at least three years before your filing for bankruptcy.
- You did not commit willful evasion or tax fraud. If you have attempted to evade paying taxes such as using a fake Social Security digit on your tax return or otherwise filed a fraudulent tax return, filing for Chapter 7 bankruptcy won’t help you discharge your tax debt.
- You must have filed a tax return. If you wish to discharge certain debt, you must have filed a tax return for such debt, at least two years prior to filing for bankruptcy. As such, if you have filed a late return (which means your extensions have expired and the IRS filed a substitute return on your place) you can’t discharge the tax in most courts. But, in some courts, it is still possible to discharge tax debt that has been filed for a late return, as long as you meet the other criteria.
- You must pass the 240-day rule. The assessment of the debt you want to discharge shouldn’t go beyond eight months old. As such, if the IRS has not assessed the debt for the last 240 days, the income tax debt cannot be discharged. On top of that, it can be difficult to determine whether or not IRS had already assessed your debt, since the tax assessment is done internally. However, if you haven’t received a bill that breaks down the total amount due by tax years, it can be an indication that IRS has probably not assessed the debt you want to discharge.
Furthermore, aside from the conditions mentioned, some jurisdictions have also additional requirements. For example, in the Ninth Circuit, filing for tax returns promptly is a must, and filing late automatically precludes a discharge.
There are other complications if you are a dual-status alien with tax debt and want to file for bankruptcy.
Moreover, it is also applicable in Chapter 7 that if you have paid off non-dischargeable taxes through a credit card, the credit card balance will be subject to a non-dischargeable debt too.
Managing Taxes with Chapter 7 Bankruptcy Filing
Also known as straight bankruptcy or liquidation, Chapter 7 is the most basic kind of bankruptcy for anybody. Here, a court-delegated trustee will supervise the liquidation of your assets to pay off the people, organization, and companies that you owe money to.
Typically, any unsecured debt such as medical bills and credit cards will be erased by filing Chapter 7. However, there are certain debts that are not forgiven through bankruptcy, these include taxes and student loans. That said, student loan debt is not automatically discharged under this type of bankruptcy. As such, in order for a student loan to be subject to discharge, you may file a complaint to determine qualifications for discharge, which initiates adversary proceedings.
Furthermore, you can only file this type of bankruptcy if the court decides that you don’t have enough source of income to pay creditors. This matter can be determined based on the means test — which examines your income to the state average and reviews your finances to see whether you have enough money to pay back what you owe to your creditors or you don’t.
Individuals including Sole Proprietors who earn under the average income for their state (based on their household size) may file for Chapter 7 bankruptcy. Why? Simply because they pass the means test based on the bankruptcy law. Furthermore, here are some signs that now is the right time to file for Chapter 7 bankruptcy:
- When your credit score is below 600;
- When you have more than $10,000 of dischargeable debt;
- When you’re keeping up with the bill and other notices, making it impossible to make ends meet each month; and
- When you don’t have an expensive property under your name.
- When you pass the means test because you are earning under the average income in your state.
- When you don’t see a way of being capable to pay off your debt over the next 5 years.
- When you’re worried about being sued for your debt.
Managing Taxes with Chapter 13 Bankruptcy Filing
While filing for Chapter 7 often forgives the money you owe, Chapter 13 or also known as Small Business Repayment Plan, basically reorganizes your debt. In this type of bankruptcy, the court will allow you to have a monthly payment plan so you can pay off all your secured debt and some parts of your unsecured debt within a span of three to five years.
As such, the amount of monthly payment you need to pay will depend on your income, the total amount of money you owe, and the number of assets you have. However, if you will file Chapter 13, the court also gets to check all your spending and put you on a strict budget.
If you’re planning to file for this type of bankruptcy but are having some hesitations, you must look at these reasons why filing for Chapter 13 can be a smart move:
- Through the Chapter 13 payment plan, you can satisfy an IRS tax lien.
- Dischargeable taxes that are generally three years old and above might be forgiven without paying any amount. However, this case depends on the amount of income you can dispose of after your necessary and reasonable expenses are subtracted from your pay.
- Dischargeable taxes won’t incur additional penalties or interest. But, you’ll still have to pay interest on non-dischargeable taxes.
- The Internal Revenue Service is obliged to put up with the plan as long as all the outstanding income taxes are included on your Chapter 13 plan while keeping your tax returns and post-petition taxes current.
Remember that any non-dischargeable tax (generally, those acquired within the last three tax periods) that won’t be erased in bankruptcy must be fully paid at the end of your Chapter 13 plan. On top of that, unlike Chapter 7, you can discharge a credit card balance from paying off the non-dischargeable tax debt in Chapter 13 bankruptcy.
Individuals who have secured debt (car, home, property, etc.), that is less than $1,257,850 and unsecured debt (medical bills, credit cards, etc.), that is less than $419,275 are eligible to file for Chapter 13 bankruptcy. Furthermore, sole proprietors or husband and wife who file jointly can also file for Chapter 13. However, businesses and corporations aren’t eligible for this bankruptcy relief and should file chapter 7 or 11 instead.
When you think you’re eligible for this type of bankruptcy and wish to file one right now, you must prove that you have filed for federal and state income taxes four years ago. Furthermore, here are some factors to consider when filing for Chapter 13:
- You can’t file a Chapter 13 if you have a previous bankruptcy petition and was dismissed within the last 180 days due to certain reason, such as failure of appearing in the court, not complying with the orders of the court, or the petition was dismissed by the creditors voluntarily.
- One must receive credit counseling from an approved credit counseling firm by the Executive Office for United States Trustees (EOUST) for at least 180 days before filing for Chapter 13 bankruptcy.
- If you have developed a debt management plan during credit counseling, such a plan must be filed with the court.
Managing Taxes with Chapter 12 Bankruptcy Filing
Chapter 12 is designed for a family of fishermen and farmers who earn regular income per year. With this type of bankruptcy, a financially distressed family of fishermen and farmers can make and carry out a plan to pay off their debts or at least some part of them.
Under Chapter 12, debtors propose a repayment plan to pay their creditors in installment within a span of three to five years. On top of that, proprietors eligible for this chapter are allowed to reorganize their debts and finances while still holding the ownership of their assets.
Generally, debtors who filed for Chapter 12 work with their creditors and a bankruptcy trustee to craft a payment plan according to their current financial obligations. Just like Chapter 13, Chapter 12 requires the debtor to surrender all their disposable income to the trustee.
How to calculate disposable income? All you have to do is subtract the necessary family and business expenses from the total income earned by your business. The calculated disposable income will be utilized to cover up payments for your debt.
Furthermore, this type of bankruptcy can be filed as an individual or an entity. As such, if you want to file as an entity, you are required to show that a single-family owns more than 50% of the equity or stock in the entity. Moreover, a fisherman or farmer is qualified when their income is only seasonal, yet can still make payments under their repayment plan.
Ultimately, Chapter 12 bankruptcy will be closed once the debtor completes the required payments to the trustee. The bankruptcy court will discharge most debts that are not covered by the repayment plan. However, there are some types of debts that can’t be discharged through Chapter 12, such as taxes and child support.
Managing Taxes with Chapter 11 Bankruptcy Filing
Another type of bankruptcy is Chapter 11 or also known as Business Reorganization. Mostly, this bankruptcy filing is used to reorganize a corporation or business. Company owners must come up with a strategic plan on how they will continue their businesses’ operation while paying off their debts. However, to make this work, both the court and creditors must approve such plans.
Generally, corporations file Chapter 11 when their tax debt is beyond the allowable amount to file Chapter 13. Aside from them, business owners that are not corporations may also file for this type of bankruptcy. Compared to Chapters 7 and 13, Chapter 11 is much more complicated and does not discharge some tax debt.
On top of that, the amount of tax debt that can be erased through Chapter 11 depends on various factors such as the following:
- Type of tax owed
- Available financial resources of an individual or a corporation
- How long the tax debt has continued
Ultimately, bankruptcy experts recommend corporations and business owners to find ways to qualify for Chapter 13 — unless their tax debt were far exceeding the limit imposed by this bankruptcy. Why? Simply because Chapter 13 allows more tax debt to be discharged compared to Chapter 11.
However, the good thing about this bankruptcy relief is that the eligible corporations and businesses can continue their operations while going through Chapter 11. With this, they can still generate income and cash flow that can aid in paying off their debts. Furthermore, the court also issues an order which keeps creditors at bay.
Can You Discharge a Federal Tax Lien?
Even If you have met all the conditions required to discharge your tax debt in the Chapter 7 bankruptcy case, you may still have a bittersweet victory. Why? Because filing for bankruptcy won’t discharge prior recorded federal tax liens.
When you file for Chapter 7, it will only abolish your personal obligation to pay back the qualified tax and prevent the IRS from going after your income and bank account. However, if the IRS has recorded a tax lien on your property before you have filed bankruptcy, the lien will stay on the property. With this, you have to pay off the recorded tax lien before you can sell such property and transfer the title to the new owner.
How Does Bankruptcy Affect Filing Tax Return?
Does declaring bankruptcy affect your filing tax returns? Well, if you file for your taxes after you have declared bankruptcy won’t impact how you file your form 1040. Debts that have been discharged through bankruptcy are omitted from your taxable income. You must remember that while the expenses of bankruptcy for individuals are not tax-deductible, businesses may claim such expenses on their tax returns.
As such, if you will file for bankruptcy, there will be another form to fill out when you file for your taxes — the IRS Form 1041. Filing for this form is essential because when you file for bankruptcy, there will be an appointed trustee who will handle your properties and assets for debt payment.
FAQ
Does Declaring Bankruptcy Clear Tax Debt?
When you declare bankruptcy, you can clear your tax debt, depending on the circumstances and nature of the situation you and your company are in. As such, certain tax obligations may be forgiven, discharged, or managed when you file for bankruptcy. Thus, if you file for Chapter 7 personal bankruptcy, all your unsecured debts and all credit card balances are eliminated, allowing you to have a fresh start and a new life.
Do You Have to File a Tax Return if You Are Going Through a Bankruptcy?
When filing bankruptcy, there are certain events where you can deal with your past tax debt. However, it can’t protect you from all the past, current, and future tax obligations or liabilities to the IRS. On top of that, regardless of what chapter of bankruptcy you file, all tax returns that will be due after your bankruptcy filing must be timely submitted, unless you file for an extension. Keep in mind that not filing a tax return can lead to an audit.
What is Automatic Stay?
An automatic stay prevents your creditor from contacting you regarding debt payment. When you file for a voluntary petition, the automatic stay will take effect. During its effectivity, even the IRS agents can’t send you a notice about your back taxes, and they are not allowed to try collecting your debt. However, if your passport was revoked due to unpaid taxes, you won’t get it back just because of the automatic stay.
What is the IRS 240 Day Rule?
The IRS 240 day rule can be applied to tax debts that the IRS assessed, following a review of a taxpayer’s amended returns. According to this rule, priority status will be granted to a tax claim if the taxes have been assessed by the IRS within 240 days of petition filing.
Conclusion
Bankruptcy could sometimes help you get out of your unpaid income tax debt, but only in particular circumstances. Since the rules and regulations for bankruptcy and taxes can be complicated and hard to understand, it’s a good idea to seek legal advice from a bankruptcy lawyer. By doing so, you will be guided accordingly when deciding whether filing for bankruptcy may help you reduce your debt or will it only make your financial situation much worst.
