Unless you’re a debt lawyer, the interplay between bankruptcy and your income taxes can be confusing. However, it is important to understand how income tax debts and refunds impact your bankruptcy claim. A single mistake can be costly.
Chapter 7 Bankruptcy and Income Taxes
In a Chapter 7 bankruptcy, you can discharge some types of income tax debt. Tax debts are dischargeable if all of the following are true:
- The debt is for unpaid income taxes (not payroll taxes or fraud penalties),
- You did not file a fraudulent tax return or willfully evade a tax obligation,
- The debt is at least three years old,
- You filed the tax return at least two years ago, and
- You pass the “240-day rule.”
However, income tax liens cannot be discharged through bankruptcy.
Even if your tax debt cannot be discharged, Chapter 7 may still offer some benefits. For example:
- Chapter 7 will get rid of most of your other debt. This may leave you with more financial ability to pay off your tax debts through an IRS installment plan.
- If you have assets that are liquidated by a bankruptcy trustee, these proceeds can help pay off some of your tax debt.
While Chapter 7 bankruptcy has many benefits, it is not always the best solution. Before filing, speak with an experienced debt lawyer. A lawyer can help you understand your options, including Chapter 13 bankruptcy or an IRS installment plan.
Chapter 13 Bankruptcy and Income Taxes
If you have significant income tax debt that cannot be discharged, a Chapter 13 bankruptcy may be your best option. Under Chapter 13, your debt is restructured and you enter into a payment plan. Over a period of three to five years, you will pay off your debts, while keeping your house and other property.
With the help of a skilled debt lawyer, you may be able to negotiate a Chapter 13 payment plan that is more advantageous than the IRS’ repayment system. And, you may be able to stop tax liens, wage garnishment, and additional interest and fees when you file for bankruptcy.
Bankruptcy Stays and Tax Debt
When you file for bankruptcy, you should list the IRS and other tax agencies as creditors in your bankruptcy filing. Once a bankruptcy is filed, debt collectors (including tax agencies) must stop collection efforts. This automatic stay applies to both Chapter 7 and Chapter 13 proceedings.
However, the automatic stay does not stop a tax audit or prosecution for tax evasion or fraud. And, you still have an obligation to file tax returns. Finally, once your bankruptcy is completed, the IRS can restart collection activities on any remaining tax debts.
What Happens to my Tax Refund?
If you receive an income tax refund, it is considered an asset. Your bankruptcy trustee can take any part of your tax return that is not exempt. Depending on your financial resources and where you live, all or most of your income tax refund may be exempt.
Income Tax Strategies
A debt lawyer can help you implement strategies that protect your assets and discharge most of your debts. For example:
- Once you file for bankruptcy, try to avoid tax refunds by reducing your withholdings,
- If you are anticipating a large income tax return, consider filing a partial-year return before you file for bankruptcy, and
- Hold off on bankruptcy until most of your tax debt is dischargeable.
An experienced debt lawyer can help you understand these strategies and incorporate them (and others) into a comprehensive debt solution.
Speak With a Debt Lawyer Today
Without the guidance of a debt lawyer, you may make costly mistakes in your bankruptcy filing. At the Northwest Debt Relief Law Firm, we provide our clients with customized debt reduction strategies and compassionate, detail-oriented advice. Contact us for a consultation today.