Three Big Ways Bankruptcy Helps with Income Taxes

Bankruptcy CAN 1) legally write off some income taxes; 2) stop IRS wage garnishments, bank account levies, and tax liens; and 3) enable a faster payoff of the taxes you must pay, by avoiding most ongoing interest and penalties.

In the last two blogs I explained what happens to tax refunds in Chapter 7 and 13. But what if instead you owe income taxes? The treatment of tax debts in bankruptcy is a complicated subject, but here today I’m covering the most basic and important powers of bankruptcy over taxes.

1) The ability to “discharge” (write-off) income taxes:

I’m not going into the detailed rules here, but let me clear up any possible confusion: income taxes can be discharged if they meet some very specific conditions. Among those conditions:

  • the age of the particular tax
  • whether and when the tax return was filed
  • whether there was any effort to enter into an “offer in compromise”
  • whether there is evidence of tax evasion

Generally the older the tax, the more likely it will be discharged, although some of the conditions are not time-based.  If you owe more than one year of income taxes, then each year of tax debt is analyzed separately. In fact portions of each tax year’s debt—tax, interest, and penalties—are treated differently in many situations. To be clear, taxes can be discharged under either Chapter 7 or Chapter 13. So determining which of these two options is better requires carefully comparing how each treats your tax debts, as well as all your other debts.

2) The “automatic stay” applies to the IRS, and to the state and local taxing authorities:

Changes in the law tend to cause confusion, to get blown out of proportion. The last major overhaul of the bankruptcy laws by Congress in 2005 allowed the IRS and other tax agencies to do certain very limited things in spite of the taxpayer having filed a bankruptcy. These limited exceptions to the automatic stay include:

  • conducting (or continuing) a tax audit (but not taking any action outside the bankruptcy court to collect the tax resulting from the audit)
  • issuing a notice of deficiency
  • assessing the taxes
  • issuing a “notice and demand” (although again without taking any collection action)

Otherwise, just like all other creditors, the IRS and its state and local cousins cannot pursue collection of any liabilities while your bankruptcy case is pending, except in the unusual event that the bankruptcy court gives special permission to do so.

3. As for taxes that cannot be discharged, Chapter 13 usually provides a way to avoid most ongoing interest and penalties, reducing the total amount of taxes to pay:

Back taxes often take a long time to pay off because interest and penalties keep accruing while you are making the payments. Especially if your payments are relatively small, the additional interest and penalties can greatly increase the total you end up paying. But in a Chapter 13 case, the penalties stop accruing as soon as soon as your case is filed. Even the earlier penalties are treated like normal debt and so are often paid little or not at all. And interest does not get added unless that tax debt is covered by a recorded tax lien.  In combination these benefits can save lots of money. This lack or reduction in accruing interest and penalties also allows you to pay other important debts before paying the taxes—such as vehicles or home mortgage arrears. This allows you to better protect those valuable possessions by paying their debts faster.