Unhappy creditors threatening to garnish wages, mortgage lenders threatening to take your home, bills piling up that you are unable to pay- these all lead people to consider claiming bankruptcy as a way of discharging eligible debts.  Fortunately filing for personal bankruptcy under Chapter 7 or Chapter 13 wipes out debts racked up from credit card purchases, medical bills, etc. but the real question is, “Does bankruptcy erase tax debt?”

Unfortunately, once you get behind on your tax payments, it is very hard to dig yourself out of that hole and the I.R.S. is definitely not forgiving.  If you are thinking about declaring bankruptcy and hoping that it will also help your situation of unpaid taxes, you may just be in luck.  Bankruptcy does not erase all kinds of tax debt, but if you meet the criteria assigned by the Federal Bankruptcy Court, you will be able to significantly reduce the tax amount that you owe, or have it erased completely.

First of all, when you file for bankruptcy an “automatic stay” will be put in place, stopping all creditors from pursuing judgements against you.  This also applies to the taxman and judges will rarely lift a stay for the I.R.S.  This is good news for you, regardless of who your creditors are and this breathing room allows you to get your bearings and sort out what to do next, financial speaking that is.

Personal bankruptcy can be filed under Chapter 7 of the U.S. Bankruptcy Code, involving a liquidation of your assets to pay off your creditors in the true meaning of bankruptcy, or under Chapter 13 where a repayment plan is established in order for you to pay off your debts over a period of 3-5 years.

When declaring bankruptcy Chapter 7 it is often, yet not always, possible to erase tax debts completely.  This is providing they meet the following specific requirements:

•    3 years – the original tax returns that you are including in your petition must have been due at least 3 years before the petition date.
•    2 years – the tax returns must have actually been filed at least 2 years before the petition date.
•    240 days – the tax owed must have been assessed at least 240 days before the petition date.

It is essential that you pay careful attention to your records before actually filing the paperwork for your bankruptcy petition because if you do not meet the requirements by even a couple of days, you will not be able to get your back taxes discharged.  You might also end up having to pay their full amount if you have not waited the minimum length of time.

In addition you must also have filed honest non-fraudulent tax returns and not intentionally made any attempt to avoid paying your taxes by filing for bankruptcy.  Basically, you have to have a good reason for declaring bankruptcy, not solely to wipe out your tax debt.

When declaring bankruptcy Chapter 13 your unsecured debt, including any tax without any liens on your property, cannot exceed $250,000 and secured debt cannot exceed $750,000.  If you have sufficient disposable income to participate in the court-supervised repayment scheme, your taxes may be discounted by a judge, if your debts meet the requirements and there is no lien recorded against your property.  Although there is no 2 year rule, the original tax returns must date from more than 3 years ago and must have been assessed a minimum of 240 days prior to filing for bankruptcy.  In that case, unfilled taxes may be paid a fraction on the dollar, and a judge may reduce any liens to equal the value of assets, if they total less than the amount of the lien.  In some cases tax liens are extinguished at the end of the Chapter 13 bankruptcy process.

Slightly different rules apply to state sales tax and while it is not dischargeable under Chapter 7 and payable in full under Chapter 13, it can be completely discharged under California state bankruptcy laws, as long as it meets the 2 and 3 year rules.

To find out if bankruptcy is right for you, consider filling out our free bankruptcy evaluation.