Every year, millions of Americans face tax fines and penalties for late or fraudulent tax returns. In fact, each year 7 million Americans fail to file their tax returns. And in 2019 the IRS unearthed 2,485 tax fraud cases in fiscal year 2019.
The fines people have to pay on back taxes can be thousands of dollars. In other words, it’s easy to slip into tax debt.
When this happens, you need to get out of it and fast. So, what are your options?
If you’re struggling to pay off tax debt then filing for bankruptcy might seem like a good option. But what happens when you file for bankruptcy, and will bankruptcy discharge your tax debt?
To find out all the answers you need about bankruptcy and back taxes, read on!
Requirements When Filing for Bankruptcy
To successfully file bankruptcy you have to meet certain criteria. If you don’t, you can say goodbye to any hope of your application being approved.
Different types of bankruptcy, or ‘chapters’, have specific qualifying requirements. These often depend on your income status. When you apply you need to supply bank statements or complete means-tested assessments.
However, there are some general rules which apply when it comes to filing bankruptcy:
- You cannot discharge debt from any case of tax fraud or tax evasion, and the penalties that come with them.
- You can only use bankruptcy to discharge tax debts that are at least three years old. For example, you won’t be able to discharge tax debt from 2012 until 2015.
- You cannot discharge tax debt on a return that you haven’t filed. So if you have penalties for failing to file a tax return, then you can’t discharge these through bankruptcy.
- Any tax debt you want to discharge must be from a tax return that you filed at least two years before your application for bankruptcy. For example, let’s say you were meant to file your taxes in 2012 but didn’t file them until 2016. In this case, you can’t discharge tax debt from this return until 2018.
- You cannot file bankruptcy until 240 days after your taxes are assessed. If your taxes were audited and reassessed then the clock restarts and you must wait a further 240 days.
- You cannot file for bankruptcy within three years of a previous application for bankruptcy. This remains the case even if you voluntarily withdrew your previous application.
Only when you meet these specific criteria can you consider filing for bankruptcy. Then, the next step is to decide which chapter of bankruptcy to file for.
What Happens When You File For Bankruptcy?
There are three main types of bankruptcy that can help you to clear your tax debt. Depending on the type of bankruptcy you file for, what happens next will vary.
When filing for bankruptcy you should take your past and current financial situations into account. You should also keep in mind any valuable assets that you have. These will become extremely important if your application is approved.
Filing for Chapter 7 Bankruptcy
Chapter 7 bankruptcy is the most straightforward kind of bankruptcy. After filing, you sell off your assets and use any money from them to pay off your creditors. Some assets, like cars or household furnishings, are exempt from sale.
This is also one of the most extreme types of bankruptcy. Almost all your assets can go up for sale, including your home and any other property you own.
After you have paid off as much as you can your remaining debts will be forgiven. This means that you no longer have to pay them off and creditors will no longer contact you for payments.
Filing for Chapter 11 Bankruptcy
Chapter 11 bankruptcy focuses on reorganizing your finances to help you clear debt. This is mainly used by businesses.
This may involve selling some but not all of your assets. So it can help you to hold onto some assets, like your home, while you clear your debt.
Reorganizing your assets means that you will have to put together a payment plan. This doesn’t eliminate all of your debt but it does make it more manageable. However, if you don’t put together a plan during the filing period then your application will fail.
Filing for Chapter 13 Bankruptcy
Chapter 13 bankruptcy doesn’t involve selling off any assets. This makes it one of the most attractive options for anyone filing for bankruptcy.
If the IRS accepts your application for Chapter 13 bankruptcy then they agree to let you pay off your debt over time. This time period usually extends over three to five years. Once this time period is up, the IRS clears any remaining debt.
So you could end up paying off a portion of your existing debt in order to clear it entirely.
But applying for Chapter 13 comes with strict requirements. In order to qualify, you must receive a steady income leading up to your application, which is not set to change. This demonstrates that you will be able to stick to a payment plan for the foreseeable future.
The Automatic Stay
The automatic stay happens immediately when you file for bankruptcy. It’s one of the reasons why this can seem like a tempting option if you’re looking for IRS tax help.
It halts the majority of legal proceedings against you and freezes collection of any debts you owe. This includes anything you have to pay in tax debt.
In fact, once you file for bankruptcy the IRS is not allowed to contact you in any way until your application has been processed. Any liens or levies on your assets will immediately halt. So it can give you time to consider and resolve your position.
However, it’s also important to note that an automatic stay won’t put a stop to all your outgoing bills. It prevents your creditors from collecting debt from you but it won’t stop you accruing debt.
In certain situations, you may have to continue making organized payments to your creditors. Or, as with Chapters 11 and 13, you will have to put together a plan for how you will pay off your debt.
If apply for a Chapter 7 or a Chapter 13 bankruptcy and continue to incur tax debt after putting in your application, then the auto-stay won’t protect you. The IRS is still entitled to collect this debt.
And an automatic stay only lasts 30 days so it’s in no way a permanent solution. Nevertheless, it can buy you time to resolve your financial difficulties without the IRS banging down your door.
Does Bankruptcy Clear Tax Debt?
So now to the big question, can filing for bankruptcy help you clear your tax debt? The short answer is yes. But how varies depending on which chapter of bankruptcy you file for.
Making a successful application for Chapter 7 bankruptcy will totally absolve your tax debt. But you’ll have to pay off as much as you can.
If you have any valuable assets, filing for Chapter 7 bankruptcy means you can kiss them goodbye. This can include your home. So it’s a big decision to make.
In contrast, filing for Chapters 11 or 13 allows you to hold onto some of your assets while you pay off your tax debt. This means that it isn’t automatically cleared. But you most likely won’t have to pay off the full amount and find yourself financially crippled.
Holding onto some of your assets and maintaining stability in your life while clearing the majority of your tax debt means Chapters 11 and 13 are a better bet.
What To Do Before You File for Bankruptcy
If you think that filing for bankruptcy is the right kind of tax help for you, then you need to know what to do next.
First and foremost you need to hire a tax attorney. They have the most experience when it comes to dealing with the IRS. And they’ll be able to offer you a wide variety of tax help services.
You’ll also need to have your paperwork in order. This will help your attorney make an application on your behalf. They will need to see your previous three tax returns.
You should also give them any tax records from your accounts. This should include an outline of your outgoings to demonstrate where your money goes and when.
This will help them to build a picture of your financial situation. Based off of this they will be able to advise you on the best Chapter of bankruptcy to file for.
When filing for bankruptcy you also need to stay on top of your bills and current tax returns. This will stop you from accruing any further tax debt.
You should submit your current tax return before you file for bankruptcy. This means you won’t risk missing the deadline while you’re busy with your bankruptcy application. Doing so would incur further penalties from the IRS.
There is only one situation in which you shouldn’t file your tax return prior to your bankruptcy application. This is if you know that you’re due a substantial tax refund. Simply put, this is because that refund will almost immediately become an asset that you may have to give back.
Your tax attorney will be able to help you decide whether or not to file your return.
Other Options for Clearing Your Tax Debt
Filing for bankruptcy to clear your tax debt might seem like an attractive option. But it does come with long-term financial implications.
Any future investors in your business will be able to see it on your record. And it could make getting a loan or mortgage extremely difficult.
So what are your other options? Well, there are a few of them. These include:
- Paying off your tax debt: Very few people can afford to do this in full. The IRS will sometimes agree to a long-term payment plan which you can use to pay back your debt. This is often means-tested so it depends on your current income being steady.
- Making an ‘Offer in Compromise’: This is a one-off payment that the IRS sometimes accepts in place of your debt. It doesn’t match your total debt and relates to your income. It is a fair payment that reflects how much you can afford to pay.
- Appealing your tax debt: This is a good way to prevent your property being levied and can clear your tax debt entirely. There are several ways to appeal your tax debt and these depend on your circumstances. For example, you can claim Innocent Spouse Relief or make a claim of Financial Hardship.
- Waiting out the statute of limitations: This is a long game but it can be worth it. The IRS has 10 years in which to collect any tax debt from you and after that, your debt is forgiven. If they contact you towards the end of this ten-year window you might be able to delay paying until you don’t have to.
However you choose to try and clear your tax debt, a tax attorney will help you succeed.
The Bottom Line
Sometimes filing for bankruptcy will help you to clear your tax debt entirely. Other times, it simply makes the debt more manageable. Either way, it’s a viable option and is worth considering.
And now that you know what happens when you file for bankruptcy you can decide which option is best for you.
But you don’t have to do it on your own. For help making your decision or for more information, get in touch today to speak to an experienced tax attorney. We’re here to help.