Are Taxes Dischargeable in Bankruptcy?
If you owe past due federal taxes that you cannot pay, bankruptcy may be an option. Other options include an IRS payment plan, an offer in compromise or currently not collectible status. If you have filed bankruptcy and have questions about an open bankruptcy, the IRS Centralized Insolvency Operations Unit handles bankruptcies that involve tax liabilities. Once you file for bankruptcy, typically the IRS will note on your IRS account transcripts that you have entered bankruptcy. Not all taxes are dischargeable. Payroll tax liabilities are not dischargeable, and certain penalties are not dischargeable in bankruptcy.
This filing of a bankruptcy petition creates a bankruptcy estate. The bankruptcy estate generally consists of all the assets the individual or entity owns on the date the bankruptcy petition was filed. The bankruptcy estate is treated as a separate taxable entity for individuals filing bankruptcy petitions under chapter 7 or 11 of the Bankruptcy Code. There are rules that must be met in order to qualify for a discharge under bankruptcy.
When a taxpayer files a petition with the bankruptcy court, the taxpayer receives the protection of the automatic stay. The automatic stay arises as a matter of law and with certain exceptions suspends most collection activity, including bank levies.
The automatic stay prohibits acts to collect taxes that arose before the bankruptcy filing. And a tax liability that is incurred after the filing a petition may not be subject to the stay. In addition, liabilities that arise after the bankruptcy petition, are generally not subject to discharge. IRS collection actions such as serving Notices of Federal Tax Lien or Levy are prohibited if they were intended to collect pre-bankruptcy debts or property of the estate. The automatic stay also stops the commencement or continuation of civil actions, including certain Tax Court cases. The automatic stay applies to all entities, including governmental units. Generally, the automatic stay to collect taxes continues until either the bankruptcy court lifts the stay, the bankruptcy case is closed or dismissed, or the debtor receives a discharge. A bankruptcy will pause the ten-year IRS statute of limitations on collection tax liabilities if the discharge is not granted or if the petition is withdrawn before a discharge is obtained.
There are exceptions to the stay. For example, the automatic stay does not prohibit:
- An audit to determine tax liability,
- A demand for tax returns,
- The issuance of a Notice of Deficiency, or
- Assessing a tax and sending a notice and demand for payment.
A bankruptcy stay can provide much need tax relief and allow taxpayers to have a fresh start by discharging their tax liabilities.
Chapter 13 Bankruptcies and Tax Discharge
For individuals, a common type of bankruptcy is a Chapter 13. In a Chapter 13 bankruptcy, the debtor will generally establish a monthly payment plan covering all liabilities. The payment plan can last for several years, and after the plan has ended, the debtor can obtain a discharge of any remaining liabilities. Before you consider filing a Chapter 13, there are some things that must be considered:
- You must file all required tax returns for tax periods ending within four years of your bankruptcy filing.
- During your bankruptcy you must continue to file, or get an extension of time to file, all required returns.
- During your bankruptcy case you should pay all current taxes as they come due.
- Failure to file returns and/or pay current taxes during your bankruptcy may result in your case being dismissed.
Certain IRS taxes can be discharged in a Chapter 13 bankruptcy.
Chapter 7 Bankruptcy and Tax Discharge
Liquidation under Chapter 7 of the bankruptcy code is also common form of bankruptcy. This type of bankruptcy is available to individuals who cannot make regular, monthly, payments toward their debts. Chapter 7 provides relief to debtors regardless of the amount of debts owed or whether a debtor is solvent or insolvent. Certain types of IRS tax liabilities can be discharged in a Chapter 7 bankruptcy as well. A Chapter 7 Trustee is appointed to convert the debtor’s assets into cash for distribution among creditors. The asses that are liquidated are offered to creditors in satisfaction of the debtor’s liabilities.
Federal Tax Refunds During Bankruptcy
You can receive tax refunds while in bankruptcy. However, refunds may be subject to delay, to turnover requests by the Chapter 7 Trustee, or used to pay down your tax debts. It is important to file all tax returns in conjunction with any bankruptcy petition.
Discharge of IRS Tax Liabilities
At the conclusion of your Chapter 7 bankruptcy you will receive a discharge of debt. A discharge releases you from personal liability for certain dischargeable debts, including certain types of taxes. Whether a federal tax debt may be discharged depends on the unique facts and circumstances of each case.
After the petition is filed, the bankruptcy court may enter an order discharging the debtor from personal liability for certain debts, including taxes. The order for discharge is a permanent order of the court prohibiting the creditors from taking action against the debtor personally to collect the debt. However, secured creditors with valid pre-bankruptcy liens may enforce them to recover property secured by the lien. If you have IRS liens, you will need to request that your tax liens be released.
For individuals in chapter 7 cases, the following tax debts (including interest) are not subject to discharge:
- taxes entitled to eighth priority;
- taxes for which no return was filed;
- taxes for which a return was filed late after 2 years before the bankruptcy petition was filed;
- taxes for which a fraudulent return was filed; or
- and taxes that the debtor willfully attempted to evade or defeat.
Penalties in a chapter 7 case are generally dischargeable unless the event that gave rise to the penalty occurred within 3 years of the bankruptcy. Only individuals may receive a discharge in chapter 7 cases; corporations and other entities cannot file a chapter 7 bankruptcy.
Federal Tax Liens
If a tax is discharged through a Chapter 7 or Chapter 13 bankruptcy, the discharged tax may still be collectable from the debtor’s pre-bankruptcy property if the IRS filed a Notice of Federal Tax Lien (NFTL) before the bankruptcy petition was filed. Perfected liens generally pass through bankruptcy proceedings unaffected, even if the debtor’s personal liability for the debt is discharged. If the IRS did not file a Notice of Federal Tax Lien before the bankruptcy petition was filed, the tax lien will generally be removed from the debtor’s pre-bankruptcy property. You will need to contact the IRS to discuss liens that survive the bankruptcy to settle the lien. There are ways to negotiate the release of the lien.
Cancellation of Debt Income
Generally, when a debt owed to another person is canceled, the amount canceled or forgiven is considered income that is taxed to the person owing the debt. This type of income is called cancellation of debt income or debt discharge income. However, if a debt is canceled under a bankruptcy proceeding, the amount canceled is not considered debt discharge income. However, the canceled debt will reduce other tax benefits to which the debtor would otherwise be entitled.
Contact a Los Angeles Tax Attorney
If you have tax liabilities that are not resolved, contact a Los Angeles tax attorney today to discuss your options to resolve your tax debt.