How Does Filing Bankruptcy Affect IRS Tax Debt?

Because of the current state of economic adversity, an increasingly greater number of Americans are either considering a bankruptcy filing, or have been forced into a compulsory filing due to unavoidable financial hardship. As a creditor in the sense that back taxes may be owed, the IRS has also seen an increase in individuals filing for debtor protection. Everyone deserves a second chance, and the IRS supports the laws governing bankruptcies in the United States by allowing certain debts to be pardoned.

If a significant amount of past-due tax is owed to the IRS, is a bankruptcy filing a productive option? How does a bankruptcy affect tax liabilities and IRS enforcement actions? What is the difference between the two types of individual bankruptcy filing options, Chapter 7 and Chapter 13?

The Automatic Stay on Collection

Bankruptcy proceedings begin with the filing of a petition with the bankruptcy court. No matter which of the above chapters the bankruptcy is submitted under, the filing of the bankruptcy creates what is called an automatic stay on collections. When a bankruptcy attorney files the petition in one's local jurisdiction, an order for relief is enacted which immediately stops ongoing and future attempts by creditors to collect pre-petition debts (open debts owed at the time the bankruptcy is filed).

This same law regarding debtor protection governs the IRS Insolvency Unit, which handles bankruptcy cases. For most debtors the automatic stay remains in effect during the time the bankruptcy remains open, and for a specified period thereafter in order to account for any potential appeal. The automatic stay prevents the IRS from making a demand for payment, either orally or in writing, and prevents such efforts to collect the tax as the issuance of a garnishment on income or bank accounts, the seizing of assets, or offsetting a current year refund to back taxes. In most cases, a tax refund will be held until the bankruptcy has been discharged. Additionally, interest stops accruing on the unpaid tax, although it may be re-assessed on any remaining balance after the bankruptcy has concluded.

The cessation of collection does not prohibit the IRS to request the filing of any un-filed delinquent returns. A tardy return that carries a balance owing to the IRS will incur additional penalties and interest. For that reason, it is recommended that all returns be filed so that any additional liabilities can potentially be covered under the bankruptcy. Any balance due assessed after the bankruptcy filing, whether via the filing of an original return or through an audit, is generally considered an open and collectable balance and is not subject to abeyance of collection.

Advantages to You and to the IRS

Bankruptcy filings have advantages to both the debtor, or the taxpayer, and the creditor, or the IRS. In addition to providing immediate temporary relief by staying all creditor actions against the debtor, certain bankruptcy options provide long-term relief by allowing a debtor to extend the time for payment of a debt, as in the case of a Chapter 13 filing, and also by yielding permanent relief through outright debt discharge, as in the case of certain Chapter 7 filings. We will discuss both in a moment.

To the IRS, a bankruptcy may concede a greater recovery of their claims. In most cases, the IRS is considered a priority creditor because the interest in the balance has likely been secured by the filing of a Notice of Federal Tax Lien. A lien is an instrument the IRS uses to set a claim on an individual's property for payment or satisfaction of a tax debt. The lien attaches to all property or rights to property the taxpayer has or acquires, and is filed in accordance with state law to make the liability public and to protect the government's interest. Because traditional debtor / creditor remedies often lead to piecemeal dismantling of a debtor's assets, a bankruptcy filing preceded by an IRS lien allows the IRS to formally reach certain assets that may have been otherwise inaccessible.

Chapter 7

A Chapter 7 filing is a basic liquidation of assets, and is the most common type of filing. Under Chapter 7, a debtor turns over his or her assets, should they have any, to a third party trustee, who essentially converts it all to cash. The trustee oversees the disbursement of the cash to the debtor's creditors. Once the payments have been fully expended, the debts are considered discharged, and the bankruptcy is then over. The discharge operates as a permanent order directed to the creditors to abstain from any further attempts to collect the balance.

Chapter 7 bankruptcies fall into either an "asset" or a "no-asset" petition. Simply stated, if a creditor has no significant assets, like a home or other real property, vehicles, investments, or valuable collections, the trustee will file the bankruptcy as a no-asset case. If a debtor has no assets to collect from, creditors are paid very little, if anything at all. However, a filing may be converted to an asset case if the trustee discovers that there are in fact assets to collect from. If this happens, creditors are notified and given time to submit their "proof of claim," or the legal right they have to collect on a debt. An IRS tax lien serves as their "proof of claim."

If an asset Chapter 7 is filed, then any creditors who do not already have a proof of claim are given opportunity to do so. Any mortgage lender or automobile financer no doubt already has a proof of claim by the fact they hold collateral on the asset via a lien. If you do not pay off the lien, they take back the asset. The proof of claim must be filed within a certain timeframe, and the debtor, or the attorney for the debtor, must be present. Asset Chapter 7 cases are then paid out according to the claim priority. Secured claims are paid first, and the IRS usually falls into that category. Unsecured priority claims (such as child support or other court orders) are junior to secured claims, and finally unsecured or general claims (such as credit card lenders) are paid last, if at all.

Chapter 13

Chapter 13 is a reorganization of an individual's debts. It is similar to a Chapter 7, but differs in the way payments are made to the creditors. Chapter13 bankruptcy law requires that the debtor submit a repayment plan. The plan is approved by the court, and outlines the amounts and priority that creditors will be paid off within an acceptable time period. This type of bankruptcy is attractive to individuals who have assets, like a home, which they may wish to keep. Individuals who have a foreseeable income source that will allow them to pay their monthly necessary expenses, with an amount left over to pay their creditors, will look to file Chapter 13. The debtor pays the trustee, and the trustee oversees the disbursements to all creditors, including the IRS. Once the plan is complete, the bankruptcy is then discharged.

Repayment plans that accompany a Chapter 13 filing typically last from three to five years. Payments are made to the trustee monthly, and the terms of the bankruptcy require that an individual make their monthly payments in a timely fashion. If a debtor fails to make payments or cannot complete their plan, the trustee may convert the case into a true Chapter 7, and assets may be made available for outright claims.

Bankruptcy and IRS Debt

IRS tax debts may or may not be dischargeable under a bankruptcy filing. The type and age of the tax debt are both important factors. Under a Chapter 7 filing, asset or no-asset, priority taxes are not dischargeable. To the IRS, a tax debt is considered priority if the due date of the return, plus any legal extension, is within three years of the bankruptcy petition date. This three-year rule means that most aged balances may be discharged, but any recent balances will still be collectible after the Chapter 7 has concluded. A stay of collection will be enforced, but the IRS will once again pursue any tax debt that is not satisfied through payments made from assets.

There are exceptions to this three-year rule as well. A liability for a tax return that was not filed by the taxpayer, but was assessed by the IRS under the Substitute for Return program, is not dischargeable. As a collection action, after repeated notices have gone out advising a taxpayer to file, the IRS may assess a balance, based on income information reported to the IRS by all payers. The return is assessed using simple a method; no credits, multiple exemptions, deductions or losses are given. This results is a tax debt owed, and is a tool the IRS uses to encourage a taxpayer to be compliant in the filing of a true and accurate, and timely, tax return. Balances assessed under this program are not dischargeable.

Additionally, any liability resulting from what has been determined to be a fraudulent return is not dischargeable. If a debtor willfully attempted to evade taxes, and has incurred civil penalties for doing so, will also not find relief under bankruptcy dischargability rules.

The same three-year rule applies to Chapter 13 reorganization plans as well. However, since regular payments are made under a Chapter 13 filing, a tax debt has the potential to be fully paid once the plan is over. This depends on how the trustee disburses the debtor's payments. An individual filing Chapter 13 will want to keep apprised as to how payments are being applied, and the percentage amounts that each creditor is getting.

For additional information regarding IRS bankruptcies, see IRS Publication 908, Bankruptcy Tax Guide.