Bankruptcy and tax debt are two financial circumstances that often go hand in hand, yet many people don’t fully grasp their relationship. In simple terms, bankruptcy is a legal process that helps individuals or businesses manage their overwhelming debts. Tax debt, on the other hand, is a specific type of debt owed to local, state, or federal taxing authorities. When people find themselves unable to pay their tax bills, bankruptcy is considered a possible solution. The critical question is whether bankruptcy can discharge tax debts, and if so, under what conditions?
Bankruptcy comes in various forms, known as “chapters”, and each one relates to tax debt in its unique way. The most common types individuals might encounter are Chapter 7 and Chapter 13. Chapter 7 bankruptcy, often called “liquidation bankruptcy,” allows for the elimination of most types of unsecured debt, including certain tax debts. On the other hand, Chapter 13 bankruptcy, also known as “reorganization bankruptcy,” involves creating a repayment plan for debts over three to five years. Tax debts play a special role here too. Not all tax debts can be erased in bankruptcy, and it largely depends on the specifics of the debt and the bankruptcy chapter filed.
Chapter 7 bankruptcy, often known as ‘liquidation bankruptcy’, has the potential to erase tax debt, but it’s not as simple as it sounds. There are very specific conditions that must be met for tax debt to be discharged under Chapter 7. Firstly, the tax debt must be income tax debt. Other types of taxes, like payroll taxes or fraud penalties, cannot be eliminated. Secondly, the debtor must have filed a tax return for the debt they wish to erase at least two years before filing for bankruptcy. Lastly, the tax debt must be at least three years old. These rules are just the basic guidelines, and there are more complexities and exceptions in the process. Therefore, erasing tax debt via Chapter 7 bankruptcy is possible, but it’s a path with specific requirements and limitations.
Chapter 13 bankruptcy is a different beast from Chapter 7 when it comes to tax debt. Known as a ‘reorganization bankruptcy’, Chapter 13 does not erase debts outright. Instead, it creates a plan to repay debts over a period of three to five years. For tax debt, this means the debtor will usually repay a portion of their tax debt through the plan. Importantly, the bankruptcy court must approve the repayment plan, which takes into account the debtor’s income and expenses. However, at the end of the repayment period, some remaining debts might be discharged, including potentially some tax debts. This discharge depends on various factors, such as the type of tax debt and how old it is. Chapter 13 bankruptcy provides a structured way to handle tax debt over time, but it doesn’t provide an immediate clean slate like Chapter 7 might.
The three-year rule is a significant guideline when considering bankruptcy as a solution to tax debt. Simply put, this rule states that income tax debt must be at least three years old to be eligible for discharge in bankruptcy. The clock starts ticking from the due date of the tax return or from the date the return was filed if it was filed late. For example, tax debt from a return due April 15, 2020, could potentially be discharged in a bankruptcy filed after April 15, 2023. It’s important to remember that the three-year rule is just one of several requirements that must be met for tax debt to be wiped out in bankruptcy.
The 240-day rule is a little known but vital component when discussing the discharge of tax debt in bankruptcy. According to this rule, for a tax debt to be dischargeable, the tax must have been assessed by the IRS at least 240 days before the debtor files for bankruptcy. This means the IRS has officially recorded the amount the taxpayer owes. If the IRS suspended collection activities due to an offer in compromise or a previous bankruptcy filing, this 240-day period may be extended. It’s worth noting that the 240-day rule, just like the three-year rule, is not the only determinant of whether tax debt can be discharged. It is one of several rules that collectively decide the eligibility of tax debt discharge in a bankruptcy proceeding.
When tax debts are unpaid, the government can create a federal tax lien—a legal claim against a debtor’s property. This lien extends to just about anything the debtor owns, such as their home, car, or even personal belongings. When someone files for bankruptcy, it’s natural to wonder what happens to this lien. The truth is, bankruptcy can often discharge personal liability for tax debt, but it doesn’t necessarily eliminate a federal tax lien. So, even if the tax debt is wiped out in bankruptcy, the lien might remain on the property. This means the IRS could potentially seize the property to cover the tax debt. However, the impact on the debtor’s property depends on various factors, like the type of bankruptcy filed and the nature of the property.
For married couples, the intersection of bankruptcy and tax debt carries additional considerations. If only one spouse has tax debt, they may be inclined to file for bankruptcy alone to protect the other’s credit. However, if both spouses have tax debt, a joint filing might be more beneficial. Additionally, the choice between filing taxes jointly or separately can have implications on the dischargeability of tax debts in bankruptcy. It’s worth noting that in states with community property laws like Wisconsin, bankruptcy filed by one spouse can affect the other’s property. Also, certain protections in bankruptcy, like the automatic stay that halts collection activities, apply differently to spouses depending on whether they file jointly or individually.
Tax compliance plays a major role in bankruptcy, especially when considering the discharge of tax debt. The tax returns for the relevant tax debts must have been filed on time, or if they were filed late, at least two years before filing for bankruptcy. Tax compliance isn’t just about filing returns; it also involves reporting income accurately. Fraudulent tax returns or willful evasion of tax payment can hinder the discharge of tax debt in bankruptcy. In short, maintaining good tax compliance—filing returns on time and reporting income truthfully—is not only a legal responsibility but also has significant implications if bankruptcy becomes necessary. It’s a valuable habit that can influence the flexibility and options available during financial hardships.
To ensure you are well-informed and prepared for the bankruptcy process, it is essential to consult with a knowledgeable bankruptcy attorney. The team at Debt Advisors Law Offices , particularly at their Green Bay office has the expertise and experience to guide you through the complexities of bankruptcy laws. They can help you understand the specific requirements and implications of tax compliance in bankruptcy, including the Wisconsin Chapter 7 means test and the new garnishment rules that protect social security. With their expertise in bankruptcy laws, you can be confident that you are making informed decisions that will positively impact your financial future.