Taxes and Bankruptcy
Contrary to popular opinion, most taxes can be discharged (i.e., wiped out) in bankruptcy. The general rule in bankruptcy is that all debts are discharged, unless specifically excepted by law.
Some Background
Bankruptcy is a legal proceeding in federal court governed by federal law and principles of equity (fairness). Its purpose is to give debtors a fresh start. Filing a bankruptcy petition usually results in the discharge of certain unsecured debts and/or gives the debtor the opportunity to pay debts in installments.
The filing of a petition operates as an automatic stay, preventing creditors (including the IRS) from pursuing collection activities without court permission.
Bankruptcy Chapters
- Chapter 7: The most common form, also known as liquidation bankruptcy. Nonexempt assets become part of the bankruptcy estate, administered by a trustee and distributed to creditors. Assets and liabilities are generally determined as of the petition date, with exceptions for inheritance, life insurance, or divorce settlements arising within 180 days.
- The estate is a separate taxable entity and may file its own return.
- Debtors may elect to divide their tax year into pre- and post-petition short years.
- Corporations do not receive a discharge in Chapter 7.
- Chapter 11: Reorganization is filed by a business entity or sole proprietorship. The debtor often serves as trustee. A reorganization plan must be approved by creditors (or sometimes “crammed down”), and priority taxes must be paid within time limits.
- Chapter 12: Similar to Chapter 13, but with liberalized rules for farmers.
- Chapter 13: For individuals with regular income. Eligibility limits are adjusted for inflation. The limits as of April 1, 2025 are < $526,700 for unsecured debt and < $1,580,125 for secured debt..
- The debtor retains assets and income but makes monthly payments under a court-approved plan over three to five years).
- Creditors must receive more than they would under Chapter 7.
- Priority taxes must be paid under the plan.
- If payments are completed, unsecured debts are discharged at the end of the plan.
Priority Taxes
Priority taxes are never discharged in bankruptcy. These primarily include trust fund taxes and recent income taxes.
Trust Fund Taxes
Taxes collected by the debtor but not paid to the government, such as:
- Employee withholding taxes
- Sales taxes
- Trust fund penalties on responsible individuals for failure to remit withholdings
Recent Taxes
Income, excise and employment taxes are “priority taxes” if the tax return due date (including extensions) was within 3 years before the bankruptcy filing or the taxes are still legally assessable at the time of filing (e.g., IRS audit still possible).
The periods can be extended by an offer in compromise.
Interest on priority taxes is treated the same as the tax itself. Penalties are often treated more favorably.
