Bankruptcy is a complex and nuanced area of law. Some back taxes owed to the IRS are dischargeable (erased) through bankruptcy, while others are not. Before filing for bankruptcy it is important for you to understand how you will be affected by filing, and which of your debts bankruptcy will erase.
Overview of Taxes and Bankruptcy
- Certain older income tax debts can be erased through bankruptcy.
- New or recent tax debts cannot be erased.
- Payroll taxes cannot be erased.
- Penalties for fraud cannot be erased.
Old Income Tax Debts That Can Be Erased
The following three criterion must be met in order for an income tax debt to be dischargeable in bankruptcy:
- The tax debt must be at least 3-years old: The tax return associated with the tax debt must have been due, including any extensions, more than 3-years before the date the bankruptcy case is filed.
- The tax return related to the debt must have been on file for at least 2-years: If the tax return related to the debt was not filed on time, that tax return must have been filed more than 2-years before the date the bankruptcy case is filed.
- The tax debt must be assessed by the IRS at least 240 days prior to filing bankruptcy: A tax debt is assessed on the date the tax liability is officially assessed at the IRS Service Center and the applicable form is signed by an IRS official.
Interest and penalties associated with that tax debt are erased as well. These rules apply to both federal and state income tax debts.
New Income Tax Debts Cannot Be Erased
As noted above, new or recently assessed income tax debts cannot be erased through bankruptcy. Therefore, it is important to avoid doing anything that will create new tax liabilities prior to filing for bankruptcy.
There are two common things people trying to avoid bankruptcy do which create new tax debts: settling debts for less than the full amount owed and drawing from retirement funds. Often these people end up filing for bankruptcy anyway, and since the new taxes are not dischargeable they must be paid back after the bankruptcy.
Settling a few of your debts for less than the full amount owed can create new tax debts because “forgiven debt” is considered taxable income by the IRS. The difference between the amount you owed and the amount you actually pay in settlement is considered income for IRS purposes. However, debts erased through bankruptcy are not taxable.
Similarly, early withdrawal from a retirement account may result in tax liabilities because it may be considered taxable income. Moreover, in general retirement accounts are fully protected through bankruptcy – meaning you get to keep those funds. It is never advisable to withdraw retirement funds in an attempt to avoid bankruptcy.
Either of these actions could create new, and nondischargeable tax liabilities for you — it is likely you will still need to file for bankruptcy and you will be worse off.
Get the Most Benefit From Filing for Bankruptcy
You want the most benefit from filing for bankruptcy so that you can enjoy the fresh financial start that you need and deserve.
Learn about the ways bankruptcy can help you. Contact us for a free consultation by clicking here or calling (912) 351-9000. We’re here to help you gain the financial freedom you deserve. The Law Offices of Barbara B. Braziel proudly serves the greater Savannah, GA area.
We are a debt relief agency. We help people file for bankruptcy relief under the U.S. Bankruptcy Code.