After the 2005 bankruptcy reform, most debtors only qualify for Chapter 13 bankruptcy. This makes it difficult for tax debts to be discharged. Those debtors who qualify for Chapter 7 can have considerably more debt discharged, including much of their tax debt. Not all tax debt can be discharged, however, and a debtor has to meet certain requirements before any tax debt can be cleared.
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If a debtor files Chapter 13 bankruptcy, the goal is to create a repayment plan rather than to clear tax debt. While the Internal Revenue Service (IRS) might make some accommodations on penalties and interest, and even forgive part of a tax debt, a Chapter 13 debtor will most likely have to pay most or all of an existing tax debt as part of the bankruptcy process. If a debtor's income is above the median income of the state and high enough to pay at least 25 per cent of the total debt over five years, then the debtor cannot file under Chapter 7.
In Chapter 7, a debtor can discharge a significant amount of debt, including some taxes. A debtor who qualifies for Chapter 7 relief must sell any personal assets that cannot be exempted under the bankruptcy rules. The proceeds of the sales are transferred to the bankruptcy trustee, who uses the money to pay off debts. After these funds are exhausted, however, the remaining debt that qualifies for discharge is permanently forgiven.
Discharging Tax Debts
According to the website FindLaw, a Chapter 7 debtor can discharge income taxes that were assessed by the IRS at least 240 days prior to the bankruptcy filing for returns that were due to the IRS at least three years prior to the filing. Other types of tax debt, such as payroll or trust fund taxes and late penalties cannot be discharged. Tax debts for years in which no tax return was filed cannot be discharged. Any debts that have resulted in an IRS tax lien on the debtor's property will remain after bankruptcy. Any taxes that are owed due to tax fraud or attempts at fraud cannot be discharged, nor can taxes owed as a result of wilful tax evasion. To qualify for discharge of tax debt, the debtor must have filed tax returns for at least two years prior to the bankruptcy filing.
Ordinarily, debts that are discharged in bankruptcy are considered taxable income by the IRS. So, even though a debtor may clear debts through the bankruptcy process, the discharge can potentially create a significant tax liability in that year. But the IRS does not treat tax debts that are discharged as income, so there is no risk of a new devastating tax liability based on discharge of tax debt. The discharge of tax debt, however, does reduce some of the other tax deductions the debtor might have otherwise claimed.
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