What do you do and not do if you owe income taxes or have ongoing tax liabilities?
Many people want to know what happens in bankruptcy if you owe income taxes. The answer will depend on the bankruptcy chapter you file under, the age of the tax debt, the date on which you filed your taxes, assessment dates, and several other factors. Your best option is to speak with a bankruptcy attorney who understands your rights and responsibilities concerning your tax and other debts as you attempt to navigate your financial struggles.
If You HAVEN’T Submitted Recent Tax Returns
For tens of millions of Americans, the last few years have been the most financially disruptive in their lifetimes. Many lives were turned upside down two years ago. If that includes you, it’s understandable that you had trouble preparing and filing your income tax returns. Indeed you may not have submitted them because you owe and have no ability to pay. That may be especially true if you were already a year or more behind on taxes at that point.
If any of this is true, you most likely realize that you’re in a scary and rather dangerous financial situation. It’s only natural to try to avoid something that’s scary, especially when there seems to be no practical way out.
The reality is that this is indeed a dangerous situation. The IRS imposes a series of penalties for not sending in income tax returns when due. For individuals, there’s a failure-to-file fee of 5% of the unpaid taxes for each month or part of a month that a tax return is late. The penalty won’t exceed 25% of your unpaid taxes. IRS’ Failure to File Penalty. In addition, there are significant steep penalties for each month you don’t file. On top of that, there are monthly penalties for the failure to pay the amount due. IRS’ Common Penalties for Individuals. States with income taxes impose similar penalties.
So the sooner you send in your tax returns, the fewer failure-to-file penalties you’ll owe. But what if you can’t pay what you owe?
If You HAVE Submitted Prior Tax Returns
What if you submitted tax returns for a prior year or two—for 2020 and/or before—and you already owe income taxes?
That may further tempt you not to submit the 2022 tax returns if you think or know that you also owe for that year. If you’re in an IRS payment plan and you can’t pay more, you don’t want to upset that payment plan. If you’re not in a payment plan and lying low, you may not want to catch the IRS’ attention. You sensibly figure nothing will catch their attention more than a new tax return showing that you owe even more.
But you know this can’t end well because the IRS knows you haven’t submitted your tax return. If you are in a payment plan with them, you violate that plan by not timely submitting subsequent tax returns. If you’re not in a payment plan, you know it’s only a matter of time. Indeed the missing tax return may well spur the IRS into action.
Besides, all unfiled tax returns are accruing serious failure-to-file penalties, quickly increasing the amount you owe.
So you’re in a real conundrum.
The Only Practical Solution
There’s only one way out of this serious Catch-22: find out your real options. Consider the following:
- Do you owe prior year income taxes for which you’ve filed tax returns? You may be able to write them off in bankruptcy. If you meet certain conditions you can “discharge” them and owe nothing. That usually includes the tax and the accrued penalties and interest.
- What if you owe income taxes that don’t qualify for discharge? Discharging other debts with a Chapter 7 “straight bankruptcy” may enable you to afford to pay the tax. The IRS and many states have reasonable payment plans, allowing you to stretch out the payments over a long period. The Chapter 7 filing would even stop any immediate collection efforts by the IRS and state for a few months. During that time you can set up a payment plan. You can even likely minimize your contact with the IRS by applying online and obtaining immediate approval.
- What if you still can’t afford an IRS payment plan? Or what if the IRS is amenable, but your state is not? Or what if you have other aggressive creditors whose debts Chapter 7 does not discharge? Examples are child or spousal support, vehicle loans, or mortgages you are behind on and need to bring current. Chapter 13 “Adjustment of Debts” stops tax collections, as well as by other special creditors, much longer than Chapter 7. Then through a court-approved payment plan, you can prioritize paying the more urgent debts. The other creditors—including the IRS and state—have to wait their turn in line. Tax interest and penalties usually stop accruing—for up to five years—saving you a lot of money.
Your Next Step
These give you just a small taste of the many ways Chapter 7 or Chapter 13 could get you out of the seemingly impossible situation you’re in.
The additional good news is that finding out more would likely cost you nothing. What you need to know is whether and how Chapter 7 or 13 could help your personal situation. Your local bankruptcy lawyer’s job is to understand your situation and give you honest advice about your options, not just about your income tax conundrum, but about all your debts and financial life.
A significant step in that direction will happen at your initial consultation meeting, which is free. Of course, you are not obligated to hire a lawyer or file any kind of bankruptcy after that meeting. But you’ll leave with crucial information about whether and how you can get out of your tax Catch-22. You’ll learn about options for getting your financial house in order. Most of the time people are deeply relieved, and often really surprised, at how good the solution is. Often our clients very much wish they would have come to see us earlier, avoiding the anguish they’ve been feeling for way too long.