Can Bankruptcy Resolve Your Federal Tax Debt?

August 4, 2020

The filing of bankruptcy puts an immediate halt on all IRS collection activities and a release on any bank account or wage levy and any property seizure. Bankruptcy law is the one body of law that trumps IRS action. However, because bankruptcy has long-term effects in the form of a tarnished credit report that remains stained for seven years. This makes getting credit and loans at reasonable interest rates all but impossible.

The prospect of bankruptcy can be used as a negotiation tool in resolving back tax debt. The IRS must consider the effect a bankruptcy filing would have on their ability to collect, and therefore on the value of an offer-in-compromise (OIC).

For most individuals, bankruptcy is available in two forms:

Chapter 7 

This is the near-complete liquidation of personal assets. Those assets are used to pay creditors, with any remaining debt discharged, although some types of debt may survive. This form of bankruptcy is commonly used in situations where the debtor does not have sufficient assets or earnings potential to satisfy their debts.

A chapter 7 bankruptcy possibility can be used as a tool when negotiating an OIC. When the IRS evaluates the OIC, they will provide their analysis of the ability to pay, which invariably is higher than what the taxpayer has offered. Chapter 7 bankruptcy could be used to demonstrate that, if filed, the IRS will receive less money than their analysis. Thus the preparation of the OIC should weigh the possibility of a chapter 7 bankruptcy.

Alas, all is not easy in the tax world. Not all tax debt is dischargeable. The following three criteria must be met for each tax year for income tax to be eligible for discharge. If any of these are not met, then the tax debt cannot be discharged and it will survive a chapter 7 filing.

  1. The tax must be at least three years  This is measured from the date that the tax would have been due. Taxes are due on the due date of the tax return, which is April 15th (or October 15th if extended) of the following year.
  2. The income tax returns for the unpaid tax debt must have been filed at least two years prior to filing for bankruptcy. If a return was never filed, or if the IRS prepared a substitute for return, the two year-period can never be met.
  3. The income tax must be assessed at least 240 days prior to a bankruptcy filing. “Assessed” means the IRS has recorded the tax liability on the taxpayer’s record. To ascertain the assessment date, a record of the account transcript should be obtained from the IRS. This transcript contains a wealth of information and should be obtained as part of any tax resolution strategy.

Income taxes that meet these three tests are considered nonpriority, while any taxes not meeting one or more of these tests are considered priority. Priority taxes survive chapter 7.

An important caveat – if the IRS has already filed a tax lien, that tax lien will remain on any property surviving a chapter 7 bankruptcy. This lien does not go away. However, if it can be shown to the IRS’ satisfaction that any remaining assets have little to no value, they will likely release the lien.

Chapter 13

 This bankruptcy proceeding is best for those with ongoing income that is insufficient to address all debts owed with any realistic prospect of ever getting out from under the debt. Unlike the IRS collections statute, which is 10 years, a chapter 13 bankruptcy’s repayment plans are between 3 to 5 years. Further, ongoing interest and penalties are stopped, with the IRS debt “frozen” – it does not continue to mount.

However, with respect to taxes, those that are priority must be paid in full as part of an overall repayment plan – that debt cannot be reduced by the operation of chapter 13 bankruptcy. As is the case with Chapter 7, IRS liens survive bankruptcy. Thus if the taxes involved are mostly priority or lien action was taken, an OIC may be the better option.

Chapter 13 imposes on all creditors the terms they will accept for complete and total satisfaction of the debts. Because of the greatly shortened repayment timeframe, a taxpayer availing himself of a chapter 13 filing will likely come out better compared to an OIC, and certainly better than a conventional installment agreement.

As noted above, it cannot be overemphasized that bankruptcy cannot be isolated to taxes. Filing for bankruptcy affects all creditors and has long-term repercussions after conclusion. If you are experiencing difficulties with tax debts, bankruptcy is a viable option under the right set of circumstances. A bankruptcy attorney should be consulted in coordination with your tax advisor.

To discuss your particular situation, or for any other matters, please contact Aronson’s tax controversy lead partner Laurence C. Rubin, CPA at 240.630.0702