In many cases, a debtor is still responsible for paying off their tax debt after bankruptcy. However, bankruptcy law grants the discharge of debt only in some circumstances.
When you file a bankruptcy case, an injunction—which is a type of court order—called the automatic stay goes into effect to stop creditors, such as the IRS, from starting or continuing collection activity (e.g. sending you letters or garnishing your income). The stay continues throughout the duration of the bankruptcy case, unless it is lifted by the bankruptcy court after a valid request by the creditor. As soon as the case is over, the IRS will be free to resume collection activity unless the tax debt has been discharged or completely paid off.
The determination of whether a debtor can discharge tax debt will depend on the type of tax, if the debtor filed a return, how old the tax debt is, and the type of bankruptcy. A debtor is more likely to have tax debt discharged in Chapter 7 bankruptcy compared to Chapter 13 bankruptcy.
Federal income taxes in Chapter 7 are dischargeable if the debtor meets all of the following conditions:
- The discharge is for income taxes (payroll taxes and penalties for fraud are not eligible for discharge).
- You filed a legitimate tax return for the relevant tax years (at least two years) before filing for bankruptcy.
- The income taxes were due at least three years (including valid extensions) before filing for bankruptcy.
- IRS tax assessment—the process of entering the tax on the books as a tax liability—occurred at least 240 days before filing for bankruptcy. If the IRS suspended collection activity during negotiation, the applicable date may be extended.
- You did not commit will tax evasion and/or tax fraud.
Penalties on taxes that are dischargeable are also eligible for discharge. Once the discharge of tax liability is complete, you are no longer liable for the taxes and the IRS may not garnish your wages or bank accounts.
Even if the discharge of tax debt occurs through Chapter 7, if the IRS placed a federal tax lien on your property prior to the bankruptcy case, it will remain after discharge. As a result, you are required to clear the title by paying off the lien prior to selling the property.
On the other hand, if you have a no dischargeable IRS debt, you can use a Chapter 13 payment plan to manage it. You’ll propose a plan to pay your IRS debt over a three- to five-year period. You will still get the benefit of discharging your older unsecured IRS debt and your nondischargeable debt will get paid in full.