5 More Crucial Facts about Income Taxes in Bankruptcy

Here are 5 more facts to help clear up the many misconceptions about how bankruptcy affects income tax debts. 

In our last blog post we’ll give you our first 5 crucial facts about income taxes in bankruptcy. Here are the rest of them.

6. A Chapter 7 “Straight Bankruptcy” Case Can Often Really Help with Income Taxes.

If you owe older income taxes, Chapter 7 case may be able to completely discharge those. And if you owe newer taxes, discharging your other debts lets you focus on paying those tax afterwards. You may well be able to enter into a reasonable monthly payment plan with the IRS and/or state to pay off any taxes you still owe. With such a payment plan:

  • interest and penalties continue to accrue
  • you must comply with the taxing agency ‘s often rigid rules for determining the monthly payment amount
  • you are at the agency’s mercy if you can’t pay as agreed

Or instead you may be able to negotiate a settlement with them for less than the balance. (This is called an Offer in Compromise with the IRS).

7. A Chapter 13 “Adjustment of Debts” Case Buys You Much More Time and Protection.

With Chapter 13 you have up to 5 years to pay the more recent tax debts that you cannot discharge. Throughout this time you and your assets are under continuous protection from collection. This protection usually lasts as long as your case is open. Before its completion you would have paid off all those taxes, so you’re effectively protected from all tax collection. This is very unlike Chapter 7 in which that protection expires just 3 or 4 months after you file your case.

8. A Chapter 13 Case Usually Stops Additional Interest and Penalties from Accruing.

In a Chapter 7 case interest and penalties continue to accrue on any taxes that are not discharged in bankruptcy. But in most Chapter 13 cases interest and penalties stop accruing on those taxes. Avoiding additional interest and penalties saves you a lot of money over a 3-to-5-year plan. That gets you out of tax debt faster. Also, you usually do not have to pay the prior-accrued tax penalties in full, and sometimes not at all. That also reduces the amount you need to pay to get out of tax debt.

9. Flexibility Is the Most Important Benefit of Chapter 13.

Paying income taxes that you can’t discharge is very flexible under Chapter 13 in two main ways:

  1. How much you pay per month to all your creditors is based on your budget. This includes the portion paid towards your nondischargeable income taxes. The amount you pay is not based on the IRS’ or state’s own rules but rather on a sensible budget with reasonable amounts for your living expenses.
  2. There is a lot of flexibility about paying other urgent creditors ahead of the taxes. This is particularly important if you have to catch up on your mortgage, vehicle, or support obligations. It also helps a great deal if you owe to both the IRS and your state tax agency.

10. Some Taxes that Are Related to Income Taxes Cannot Be Discharged.

There are taxes that the taxpayer collects from someone else and then must pay to a tax agency. The common example is withholding taxes: an employer withholds taxes from an employee’s paychecks on behalf of the tax authority. That employer would be liable for any withheld money that was not turned over as required. Beyond the employer being liable, any person who was responsible to pay those taxes could be held liable. With the IRS that could include the employer’s managers and sometimes even high-level staff (the never-dischargeable “trust fund recovery penalty”).


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