The Basics: Income Taxes in Bankruptcy

Just because you owe income taxes, that doesn’t necessarily make your bankruptcy case complicated.

1. Your bankruptcy filing stops all tax collection just like it stops all other debt collections.

The Internal Revenue Service, your state income tax agency, and all tax agencies have to honor the “automatic stay” and so must stop all collections when you file your bankruptcy case. They are no different in this respect than any other creditor. That means no garnishment of wages, levies on your vehicle and other possessions, or tax lien on your home and other real estate.

2. There are some VERY limited, sensible exceptions to the above.  The IRS and state tax agencies CAN, in spite of your ongoing bankruptcy case and without getting “relief from stay” from the bankruptcy court: start or continue an audit to determine your tax liability, send you a notice that you owe taxes (but can’t try to collect on it), make a demand for a tax return, and make an assessment of a tax.   

3. Some income taxes CAN be discharged (legally written off) in bankruptcy, even in a simple Chapter 7 or Chapter 13 case. Although the rules can get complicated, MOST of the time it just comes down to meeting two conditions (there are others but they don’t often apply): 1) the pertinent tax return was ACTUALLY FILED more than 2 years before the bankruptcy case was filed, and 2) the tax return was FIRST DUE more than 3 years before the bankruptcy case was filed, AFTER adding the length of any tax return filing extension.

4. Some income taxes can never be discharged. If a debtor filed “a fraudulent return or willfully attempted in any manner to evade or defeat” a tax, that tax can never be discharged. Nor can a tax for which a required tax return was never filed.

5. Also some taxes that are related to income taxes can never be discharged. Taxes that are collected by the taxpayer from a third party and required to be paid to the tax agency are never dischargeable. This includes withholding taxes—so-called “trust fund” taxes—that an employer withdraws from employee paychecks on behalf of the tax authority. The employer would be liable for any withheld money that was not turned over as required. Also, any person who was responsible to pay those taxes but failed to do so could be held liable, including the employer’s managers and sometimes even high-level staff, through the never-dischargeable “trust fund recovery penalty.”  Most sales taxes, and excise taxes collected from customers (e.g., federal gasoline tax), are also in this category of third-party-collected, never-discharged taxes.

6. A bankruptcy case cannot discharge any taxes that become due after the case is filed. That’s true of all debts—bankruptcy only affects those that are legally owing as of the date of filing. Especially under Chapter 13 it may make sense to delay filing until the current year’s tax is due so that it can be included in the payment plan and you can be protected from its collection.

7. A Chapter 7 case may well help with income taxes, perhaps discharging some, and then letting you focus on paying the rest after completing the bankruptcy case. It can be sensible to discharge all or most of your other debts, and then either enter into a reasonable monthly payment plan with the IRS and/or state to pay off then entire remaining amount owed, or negotiate a settlement with them for less than the balance (called an Offer in Compromise with the IRS). With a payment plan, interest and penalties continue to accrue, you must comply with the taxing agency ‘s often rigid and onerous rules in determining the payment amounts, and you are at its mercy if you cannot pay as agreed.

8. Under Chapter 13, nondischargeable “priority” income taxes can and indeed must be paid during the course of the 3-to-5-year payment plan.  But throughout this time you and your assets are under the continuous protection of the “automatic stay,” for as long as your case is alive, usually until you have paid off all the taxes. This is very unlike Chapter 7 where that protection expires usually before you would even approach the tax agency for a payment plan or settlement.

9. During a Chapter 13 case usually no additional interest and penalties accrue. This is again in contrast to Chapter 7, where interest and penalties continue to accrue on any taxes that are not discharged in bankruptcy. Avoiding additional interest and penalties under Chapter 13 can save a substantial amount over a 3-to-5-year plan, enabling a faster payoff. Also, you usually do not have to pay in full the tax penalties that had accrued as of the date of filing, and sometimes do not have to pay them at all, again reducing the amount you need to pay.

10. Flexibility is the most important benefit under Chapter 13. First, how much you pay per month towards the priority tax debt (as well as to all your creditors) is based on your budget, not on some tax authority’s rules designed for its own benefit. Second, there is a fair amount of flexibility about paying other urgent creditors ahead of the taxes (to catch up on your mortgage, vehicle, or support obligations, for example), likely very much more so than if it  were up to the tax authority’s discretion. 

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