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Bankruptcy and Tax Discharge: Basic Rules


Most people voluntarily pay all their taxes on or before the due date. But 15 percent of taxpayers either don’t pay in full or don’t pay at all. That percentage may seem small, but given that the American IRS bill is over $1 trillion a year, that’s a lot of money. And, the IRS has tools to collect this money that private debt collectors only dream of.

Some limited relief is available, mostly repayment plans. However, not everyone qualifies for these plans. Furthermore, penalties and interest keep adding up until the balance is paid in full, whether or not the taxpayer is on a payment plan.

Bankruptcy, especially a bankruptcy guided by an experienced Chicago bankruptcy lawyer, is a much better option than these payment plans. A bankruptcy judge, not an IRS bureaucrat, oversees the bankruptcy. Additionally, debtors have more rights in court than they have in bureaucratic proceedings. Finally, and perhaps most importantly, as long as the case is pending, the IRS cannot add penalties and interest to the balance at least in most cases.

Discharge in a Chapter 7

Many government-affiliated debts, like back taxes and student loans, are priority unsecured debts which are only dischargeable in certain cases. Discharge rules for student loans have changed significantly in recent years. But income tax discharge rules haven’t changed much at all. These rules include:

  • Income Tax: The Bankruptcy Code doesn’t define “income tax,” so we don’t specifically know what this definition includes. We do know that it excludes property taxes and payroll trust fund taxes.
  • Three Years: The tax debt to be discharged must be at least three years old. This delay usually means the IRS has attempted to collect the debt on its own. Frequently, however, these efforts haven’t gone very far past the threatening letter stage.
  • Two Years: Taxpayer-filed returns must have been with the IRS for at least two years. The substitute returns that the IRS files on a taxpayer’s behalf when s/he doesn’t file one do not count. Bear in mind that extensions, if granted, affect the due date.
  • 240 Days: This rule derails many discharge applications. Back taxes are nondischargeable if the IRS has assessed the debt within the past eight months. An attorney must examine a tax transcript to determine when the IRS last assessed the debt. Generally, however, the IRS assesses tax debt before it sends a letter that includes the total amount due.

Even if a judge later determines the income tax debt is nondischargeable, the Automatic Stay still takes effect. Section 362 of the Bankruptcy Code wipes out all wage garnishment orders and payment plan arrangement. In fact, the Automatic Stay prohibits the IRS from contacting debtors in any way whatsoever.

Repayment in a Chapter 13

A good Chicago bankruptcy lawyer always has Plan B ready. In this context, Plan B is usually repayment of the tax debt through Chapter 13 bankruptcy.

Usually, debtors have five years to pay all allowed claims, a category that includes past-due income tax. This payment plan is based on the debtor’s income, not based on the amount due. So, the IRS must wait for its money just like everyone else.

Many people combine a Chapter 7 and a Chapter 13 into a Chapter 20 bankruptcy. They initially file Chapter 7 to quickly discharge past-due taxes. If the judge denies their requests, they file Chapter 13 to take advantage of the extended repayment plan.

Work With a Thorough Cook County Lawyer

No matter what kind of financial problem you are having, bankruptcy could be a way out. For a confidential consultation with an experienced bankruptcy attorney in Chicago, contact the Bentz Holguin Law Firm, LLC. Convenient payment plans are available.



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