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Eliminating Tax Debts in Bankruptcy

Most taxes cannot be eliminated in bankruptcy but some can.

You may hear radio commercials offering the hope of eliminating tax debts in bankruptcy. But it's not as simple as it sounds. Most tax debts can't be wiped out in bankruptcy -- you'll continue to owe them at the end of a Chapter 7 case, or you'll have to repay them in full in your Chapter 13 plan.

If you need to discharge tax debts, Chapter 7 will probably be the better option -- but only if you qualify for Chapter 7 (see Who Can File for Chapter 7 Bankruptcy?) and your debts qualify for discharge.

When You Can Discharge a Tax Debt

You can discharge (wipe out) debts for federal income taxes in Chapter 7 bankruptcy only if all of the following conditions are true:

• The taxes are income taxes. Taxes other than income, such as payroll taxes or fraud penalties, can never be eliminated in bankruptcy.
  
• You did not commit fraud or willful evasion. If you filed a fraudulent tax return or otherwise willfully attempted to evade paying taxes, such as using a false Social Security number on your tax return, bankruptcy can't help.
  
• The debt is at least three years old. To eliminate a tax debt, the tax return must have been originally due at least three years before you filed for bankruptcy.
  
• You filed a tax return. You must have filed a tax return for the debt you wish to discharge at least two years before filing for bankruptcy.

You pass the "240-day rule." The income tax debt must have been assessed by the IRS at least 240 days before you file your bankruptcy petition, or must not have been assessed yet. (This time limit may be extended if the IRS suspended collection activity because of an offer in compromise or a previous bankruptcy filing.)

The Effect of Federal Tax Liens

If your taxes qualify for discharge in a Chapter 7 bankruptcy case, your victory may be bittersweet. This is because prior recorded tax liens are not affected by your filing. A Chapter 7 bankruptcy will wipe out your personal obligation to pay the debt, and prevent the IRS from going after your bank account or wages, but any lien recorded before you file for bankruptcy remains. In effect, this means you'll have to pay off the lien in order to sell the property.

Will Bankruptcy Set Off the IRS's Audit Radar?

QUESTION:

I am preparing to file for Chapter 7 bankruptcy and have been advised that the IRS will look at this as a HUGE red flag. Apart from not understanding why, I am more curious as to what to expect. Do you have ideas on this?

ANSWER:

We are not aware of any policies -- written or unwritten -- targeting bankrupts for audits or other IRS problems. With more than 1.5 million people having filed for bankruptcy in each of the first five years of the new millennium, the IRS would have quickly run out of person power if it had targeted or specially screened all or most of them. Of course, this doesn't guarantee that your return won't be singled out for special attention, but the IRS hasn't indicated that filing for bankruptcy automatically moves you to the head of the audit line.