Bankruptcy and IRS Tax Debt - the Basics You Need to Know

According to uscourts.gov, approximately 1.6 million individuals filed for debtor protection under bankruptcy code in calendar year 2010, an increase of 8 percent from 2009.

That's a lot of people owing a lot of money.

The IRS has also seen an increase in individuals listing the federal government as a creditor as they try to absolve themselves of mounting tax debt. So the question is, does a bankruptcy filing clear IRS debt?

The answer? Not likely.

There are a few things to consider however. One of the main factors is the Chapter under which the bankruptcy is filed. Chapter 7 and Chapter 13 are both available for individuals who are looking to pardon themselves of escalating debt.

Chapter 7

Chapter 7 is a liquidation of your assets. It is the most common type of bankruptcy filing. An individual in Chapter 7 catalogs all of their creditors, and then turns over certain assets to a trustee, who essentially liquidates the assets and disburses the money to the creditors, according to the claim priority.

Secured debts, like a mortgage loan, car repayment or IRS debt, will receive payment over unsecured debts, like consumer credit cards.

Once the funds have been distributed, the bankruptcy is then discharged.

Under Chapter 7, priority IRS tax balances are not dischargeable. A priority debt is generally considered any tax return showing a balance, or any subsequent tax assessment that has been made within three years prior to the bankruptcy petition date (the date the bankruptcy is formally filed in the local court jurisdiction).

Balances that are older than three years may be dischargeable, but the type of tax, among other things, also comes into play. Balances assessed as a substitute return under Internal Revenue Code § 6020(b) are not dismissible. Nor are balances resulting from a fraudulent return or civil penalties assessed for unpaid trust fund tax. Consult your bankruptcy attorney about these conditions.

Chapter 13

A Chapter 13 filing is a reorganization of debt into a payment plan. A repayment plan is submitted and approved by the court; the plan outlines who will be paid and the amount. These three- to five-year plans are overseen by a third party trustee who is responsible for ensuring that the payments are applied according to the plan.

Under a Chapter 13, IRS tax balances may receive some payment. However, once the plan is completed and the bankruptcy is discharged, any remaining IRS balance will once again be reactivated into collection.

Automatic Stay

No matter which Chapter a bankruptcy is filed under, the IRS is governed by the automatic stay of collections. This means that any enforcement action, such as a levy or garnishment on your wages, must be released once the IRS is made aware that a bankruptcy has been filed.

Additionally, the stay of collections prevents the IRS from efforts related to collecting the debt, including making telephone calls and sending letters. Once the bankruptcy is concluded, collection of the balances can commence, so be sure to be proactive about contacting the IRS to resolve any remaining tax balances.

For more information on this topic, see IRS Publication 908, Bankruptcy Tax Guide, as well as the related articles linked below.

More from this Contributor:

The basics behind a bankruptcy filing

How does a bankruptcy filing affect IRS tax debt?

What is the difference between an IRS levy and a tax lien?