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Tax Debt and Bankruptcy: What You Need to Know

When you're in a lot of debt, you may owe money to numerous creditors—including the IRS. Wondering what happens to your tax debt if you file bankruptcy? Well, that depends on several different factors, and it can vary from situation to situation. Here's what you need to know.

Tax Debt Expires

There is a collection statute on tax debt. That means that the IRS only has a limited period of time to collect the debt, and after that point, the agency no longer has a legal right to pursue the debt. In most cases, that is ten years.
That means if your debt is more than ten years old, you don't have to include it in your bankruptcy filing because the IRS can't collect it anyway. You may be wondering why you should even bother paying if the debt is just going to expire. The answer is simple—the IRS may attempt to take your assets or garnish your wages before expiration.

Filing for Bankruptcy Can Prevent the IRS From Seizing Your Assets

When you file for bankruptcy, the courts issue a stay. This essentially means that all collection activity on your debts must stop. Generally, that also applies to tax debt, and once your bankruptcy lawyer starts the process, the IRS can't garnish your wages or levy your assets. However, if the IRS has already started that process, there is no guarantee that filing can reverse the garnishment or asset seizure.

Tax Debt Is Priority Debt

To understand priority debt, it's important to understand the structure of the two most common types of bankruptcies. The two most common types of bankruptcy for most consumers are Chapter 7 and Chapter 13.
With Chapter 7, you essentially liquidate all of your non-essential assets. Generally, you get to keep your home, primary vehicle and personal items, such as clothing. Then, the courts use the money from the sale of your assets to pay your creditors, and any remaining debt is discharged.
Under a Chapter 13 bankruptcy, you get to keep your assets, but you have to make repayments over a three to five year period. The courts determine how much your repayments need to be.
In both cases, the first debts that are paid off are your priority debts. Tax debt is almost always considered priority debt. As a result, it will get paid off before most other debts.

Some Tax Debt Can Be Eliminated

In some cases, tax debt can be eliminated. For instance, imagine you are filing Chapter 7 bankruptcy. The courts liquidate your assets, and as explained above, that money covers your priority debts—your tax debts. However, if there is still tax debt remaining after the asset liquidation, that tax debt can just be discharged or erased.

Rules Vary Based on the Type of Tax Debt

In most cases, you can only discharge income tax debt in a bankruptcy. If you have sales tax debt or unpaid payroll taxes from your business, you cannot write that off. Generally, you also cannot write off property tax in a bankruptcy, but many states offer special programs where you can lower your property tax bill based on age, disability and whether or not you are an active member of the military.
That said, it's important to note that there are also rules on the income tax you write off. As a general rule of thumb, you can only write off tax debt that is at least three years old. Additionally, the IRS must have assessed the debt at least 240 days ago.
If the IRS just assessed the debt, you can't include it in your bankruptcy even if it's from a tax year that's more than three years ago. There may also be other stipulations, such as being on time with current tax filings and payment requirements.
To learn more about bankruptcy and to figure out if it's the right option for you, contact Terry E. Hurst, Attorney at Law. We'll start with a consultation and go from there.