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Facing financial difficulties is something most people experience at least once in their lives. The stress of not being able to make ends meet can sometimes lead to filing for bankruptcy. If you have a tax liability, you may be wondering if filing for bankruptcy clears it. The answer is that it depends on your specific case and the type of bankruptcy you may file for. Read more to find out about the different kinds of bankruptcy.
Understanding bankruptcy and IRS tax liability
In the United States, there are 6 numbered chapters of bankruptcy filings. Chapters 7, 11, 12, and 13 apply to individuals in different circumstances. Every situation is different, and you would want a bankruptcy attorney to assess what best next steps may be. We will delve into an overview of different types of bankruptcy and possible outcomes below.
If you owe past due federal taxes that you cannot pay, you may want to consider an IRS payment plan, or an offer in compromise. If those options don’t work out, then you may consider filing for bankruptcy as an option of last resort.
How is tax liability defined? Your total tax liability is the combined amount of taxes you owe the IRS from income tax, capital gains tax, self-employment tax, and any penalties or interest. This also includes any past-due taxes that you haven't paid in previous years.
The most common types of bankruptcy
Partnerships and corporations file bankruptcy under Chapter 7 or Chapter 11 of the bankruptcy code. Individuals may also file under Chapter 7 or Chapter 11.
Other types of bankruptcy include Chapters 9, 12, and 15. Cases under these chapters of the bankruptcy code involve municipalities, family farmers and fishermen, and international cases. We will go into more detail about these types further in this article.
Chapter 7 bankruptcy
Chapter 7 bankruptcy is the most common kind for individuals. This is often seen as a type of bankruptcy that can quickly clear away debts. It’s also called “liquidation bankruptcy,” because you must sell nonexempt possessions and use the proceeds to repay your creditors. It’s also referred to as a “straight bankruptcy,” because there are no drawn-out repayment plans. You do get to keep exempt assets and possessions, up to a limit. Often-exempt possessions include the car you may need to get to and from work and your home.
Always work with a bankruptcy attorney in your state to determine what would be considered exempt and nonexempt assets. Once the process is complete, the rest of your included debts are discharged.
Although it's often a last resort, understanding how a Chapter 7 bankruptcy might help you could be important if you and your family are struggling with your finances.
At a high level, here's how a Chapter 7 bankruptcy works once you file for it:
- The court automatically places a temporary stay on your debts. The stay can stop debt collection efforts, home foreclosure, wage garnishment, property repossession, eviction, and utility turn-off.
- A court-appointed trustee takes and sells certain property. The trustee reviews your finances and oversees your Chapter 7 bankruptcy. The trustee can sell certain property the bankruptcy won't let you keep (nonexempt property) and use the proceeds to repay your creditors. This might include vehicles, homes, jewelry, collectibles, and money in your bank account. The trustee will pay off unsecured debts that aren't dischargeable first—called “priority unsecured claims.”
- You won't lose everything. But the list of property you don't have to sell (exempt property), and the total value that you can exempt, varies by sta Some states let you choose between their exemption list and the federal exemptions.
- The court discharges your remaining liabilities--the remaining debt that's included in your bankruptcy.
Some types of debt aren't dischargeable through a Chapter 7 bankruptcy, including child support, alimony, court fees, and some tax debts.
At the end of your Chapter 7 bankruptcy process, you will receive a debt discharge, or cancellation of certain liabilities. A discharge releases you from personal liability for certain dischargeable liabilities. Some taxes may be dischargeable. Whether a federal tax debt may be discharged depends on the unique facts and circumstances of each case, according to the IRS. You should consult with a bankruptcy attorney to figure out which tax debts may be discharged and discuss your options.
Chapter 13 bankruptcy
Chapter 13 bankruptcy is only available to wage earners, the self-employed, and sole proprietors (businesses owned by one person).
Before you consider filing a Chapter 13, here are some IRS guidelines surrounding the process:
- You must file all required tax returns for tax periods ending within 4 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 bankruptcy case being dismissed.
If you have unfiled, past-due federal tax returns, the IRS files an “estimated proofs of claim.” Creditors, including the IRS, can file estimated proofs of claim, to give an estimate of what the IRS believes you owe to them. It’s crucial to have this proof of claim for any federal taxes you owe before confirmation of your Chapter 13 plan. This will help you avoid paying more than you need to and minimizes discharge of the tax debt issues upon completion of the Chapter 13 plan.
To help the IRS quickly amend an estimated proof of claim, you’d work with your Tax Pro and an IRS bankruptcy specialist, with a copy of each late-filed return for each year on the proof of claim. This helps to avoid unnecessary litigation on the proof of claim or discharge of the liability.
Like with other forms of bankruptcy, if you successfully complete your bankruptcy plan, you will receive a discharge of debt. A discharge releases you from personal liability for certain dischargeable debts. Whether a federal tax debt may be discharged depends on the unique facts and circumstances of each case. Consult with your bankruptcy attorney, the IRS, and the courts to determine which tax debts may be discharged.
Broad overview of common types of bankruptcies and implications
Please note that this is for high-level informational purposes only and doesn’t capture all the details you’d need to know about the various types of bankruptcies. Always work with your team of professionals and experts about your specific situation.
|Chapter||Who Can File||Purpose||Length||Prepetition Taxes||Post-Petition Taxes|
|7||Individuals Businesses Corporations Partnerships||Liquidation – Trustee takes control of debtor's assets and tries to sell them to pay creditors.||Usually, 90 to 120 days||Debtor must file returns for the last 4 tax periods. Discharge: Will eliminate (discharge) personal liability for tax debts older than 3 years.||Debtor must timely file income tax returns and pay income tax due. No discharge of post-petition tax liabilities.|
|13||Individuals (including sole proprietors)||Adjustment of debts – Trustee distributes debtor payments to creditors.||5 years – 3 years if hardship||Debtor must file returns for the last 4 tax periods. Discharge: Will eliminate (discharge) tax debts paid in the plan and tax debts older than 3 years.||Debtor must timely file income tax returns and pay income tax due. No discharge of post-petition tax liabilities.|
|11||Individuals Corporations (including limited liability companies) Partnerships||Reorganization: Allows debtor to pay reduced amount to creditors and stay in business. May also be a liquidation.||Usually 5 years||Debtor must file returns for the last 4 tax periods. Discharge: Will eliminate (discharge) tax debts paid in the plan and tax debts older than 3 years.||Debtor must timely file income tax returns and pay income tax due. No discharge of post-petition tax liabilities.|
Source: Internal Revenue Service (IRS)
The impact of bankruptcy on IRS tax liability
As mentioned above, every case is different and you should work with your Tax Pro, bankruptcy attorney, and the IRS to ensure that you understand all your options and obligations.
In general, if you decided to file for bankruptcy and listed the IRS as a creditor in your bankruptcy, the IRS would receive an electronic notice about your case from the U.S. Bankruptcy Courts within a day or two of the petition date. You’d want to make sure that you confirm that the IRS has all the information they need.
To get the fresh start you’re after, it is important that you do not continue to take on more liability during or after a bankruptcy. If all or part of the reason you are filing bankruptcy is overdue federal tax debts, you may need to increase your withholding and/or your estimated tax payments.
It’s also important to note that bankruptcy will affect your credit score. Your payment history is the most important factor in deciding your credit score, and filing bankruptcy means that you won't be paying covered debts in full as you initially agreed.
A Chapter 7 bankruptcy will remain on your credit reports and affect your credit scores for 10 years from the filing date; a Chapter 13 bankruptcy will affect your credit reports and scores for 7 years.
Questions around tax liabilities and bankruptcy can be very complicated. Find a Jackson Hewitt Tax Pro near you to discuss your specific tax situation.
About the Author
Mark Steber is Senior Vice President and Chief Tax Information Officer for Jackson Hewitt. With over 30 years of experience, he oversees tax service delivery, quality assurance and tax law adherence. Mark is Jackson Hewitt’s national spokesperson and liaison to the Internal Revenue Service and other government authorities. He is a Certified Public Accountant (CPA), holds registrations in Alabama and Georgia, and is an expert on consumer income taxes including electronic tax and tax data protection.