Tax Debt and Bankruptcy

Contrary to common belief, income tax debt is dischargeable in Chapter 7 bankruptcy if it meets specific timing and procedural tests. Many of our Miami clients arrive thinking the IRS debt has to be paid in full. Often the older portions can be wiped out in a Chapter 7 case, and the remainder paid through Chapter 13 without further interest or penalties accruing.

The rules below apply to federal income tax. State income tax follows similar rules in most states (Florida has no state income tax, so this is mainly relevant for clients with debt from other states). Different rules apply to payroll trust-fund taxes, sales taxes, and certain other tax categories.

The Three Timing Tests for Income Tax Discharge

Federal income tax debt can be discharged in Chapter 7 only if all three of the following are true on the date of filing:

1. The Three-Year Rule

The tax return for the year in question was due (including extensions) more than three years before the bankruptcy filing. For tax year 2020, the return was due April 15, 2021 (or October 15, 2021 with extension). The earliest a 2020 tax debt becomes dischargeable is April 15, 2024 (or October 15, 2024 if the taxpayer extended).

2. The Two-Year Rule

The tax return was actually filed more than two years before the bankruptcy. A late-filed return restarts this clock from the date of late filing. Some courts (the strict "one-day-late" rule) hold that a return filed even one day late never qualifies as a "return" for discharge purposes – the Eleventh Circuit has expressed sympathy for this position in dicta. We address late-filing risk carefully.

3. The 240-Day Rule

The tax was assessed more than 240 days before the bankruptcy filing. Most income taxes are assessed shortly after the return is filed, but audit adjustments and amended returns reset the assessment date.

Additional Requirements

• The return must not have been fraudulent
• The taxpayer must not have willfully attempted to evade or defeat the tax

Tax Liens Survive the Discharge

Even when the underlying tax debt is discharged, a previously-recorded federal tax lien (Notice of Federal Tax Lien) remains attached to property the taxpayer owned at the time of recording. The discharge eliminates personal liability for the tax; it does not strip the lien on the property. The lien continues to encumber the property for sale and refinance purposes until paid, expired (10-year IRS lien life, subject to renewal), or released.

This dynamic matters most for taxpayers with substantial equity in real estate. Strategic timing – ideally before a tax lien is recorded – can preserve the option to discharge the tax debt without the lien complication.

Trust-Fund Taxes: Generally Not Dischargeable

"Trust-fund" taxes – the employee's share of payroll taxes the employer is required to withhold and remit – are non-dischargeable as to the responsible individuals personally. Section 6672 of the Internal Revenue Code makes the responsible person personally liable for unpaid trust-fund amounts. Small-business owners with unpaid payroll-tax liability cannot discharge this exposure in personal bankruptcy.

Sales Tax

Florida sales tax operates under a similar trust-fund framework. Unremitted sales tax is generally non-dischargeable for responsible individuals personally.

Chapter 13 and Tax Debt

Even tax debt that does not qualify for discharge in Chapter 7 can be managed effectively in Chapter 13:

• Recent income tax that does not yet meet the three-year rule is a "priority claim" and must be paid in full through the plan
• Interest and penalties on priority tax claims generally stop accruing during the plan
• Non-priority older tax debt that does qualify for discharge can be treated as general unsecured and paid only the percentage other unsecured creditors receive
• Tax liens can be paid as secured claims to the extent of equity in the liened property, with the unsecured remainder discharged

The IRS Offer in Compromise Alternative

For some taxpayers, an IRS Offer in Compromise produces a better outcome than bankruptcy – particularly for taxpayers with low income and few assets whose collection statute is approaching expiration. We compare the OIC analysis with the bankruptcy analysis for clients with substantial tax debt.

Installment Agreements and Currently Not Collectible Status

Outside of bankruptcy, the IRS offers two other tools that sometimes resolve a tax problem without the cost of a filing. A streamlined installment agreement is available to taxpayers who owe under $50,000 in combined tax, penalty, and interest and can pay the balance within 72 months. The IRS will accept the proposal without requiring detailed financial disclosure. For larger balances or longer terms, a regular installment agreement is available but requires Form 433-A or 433-F with full disclosure of income, expenses, and assets.

Currently Not Collectible (CNC) status is the IRS equivalent of judgment-proof status. If a taxpayer's allowable expenses meet or exceed income, the IRS will suspend active collection – no levies, no garnishments – while the collection statute continues to run. For older clients on Social Security with limited assets, CNC often produces the same practical result as discharge: the IRS leaves them alone until the ten-year collection statute expires and the debt falls off. See our page on bankruptcy alternatives.

The Collection Statute Expiration Date (CSED)

The IRS has ten years from the date a tax is assessed to collect it. After that, the debt is gone by operation of law. This is the Collection Statute Expiration Date, or CSED. The CSED can be tolled (paused) by certain events – bankruptcy, an offer in compromise under review, certain installment agreement applications, and a taxpayer's time outside the United States – so the practical CSED is sometimes later than ten years after assessment.

For a taxpayer whose CSED is close, filing bankruptcy can be counterproductive: the automatic stay tolls the CSED for the duration of the case plus six months. Pulling the IRS Account Transcript and Record of Account for each tax year before filing is the only way to determine the CSED accurately. The transcripts are free and we order them at the start of any tax case.

Florida Department of Revenue and Other State Tax

Florida has no state income tax, so the Florida Department of Revenue does not have a comparable income-tax claim against most individuals. The Department does collect sales and use tax and reemployment tax. Section 213.29 of the Florida Statutes makes officers and employees of a business personally liable for unremitted sales tax in the same way IRC § 6672 does for federal payroll taxes. Many Miami residents moved here from states with income tax. Old state income tax debt from a prior state of residence follows the same general dischargeability framework as federal income tax, but with state-specific wrinkles – we coordinate with state-tax counsel when the analysis is close.

Strategic Timing of the Filing

Tax debt cases reward patience. A filing six weeks too early can leave $40,000 of otherwise-dischargeable income tax stuck as non-dischargeable priority debt for the entire life of a Chapter 13 plan. Key timing considerations:

• The three-year clock runs from the return due date including extensions. A Form 4868 for tax year 2021 means the clock does not start until October 15, 2022.
• The two-year clock runs from the actual filing date of the return, not the due date.
• An audit assessment, a substitute-for-return assessment, or an amended return resets the 240-day clock.
• Time during which a prior offer in compromise was pending, plus 30 days, is added to the three-year and 240-day periods.
• Time during which collection was barred by a prior bankruptcy, plus 90 days, is added to the same periods.

Tax Refunds and the Bankruptcy Estate

A tax refund earned for the year before a Chapter 7 filing is property of the bankruptcy estate to the extent it represents pre-petition earnings. For a filing in mid-year, the refund is prorated. Florida's personal-property exemption covers $1,000 per debtor (or up to $5,000 if no homestead is claimed), which can absorb a modest refund but not a large one. Adjusting withholding before filing is one of the simplest pre-bankruptcy planning steps.

Chapter 13 Treatment of Priority Tax

Under 11 U.S.C. § 507(a)(8), recent income tax (within the three-year window) and trust-fund taxes are priority unsecured claims that must be paid in full over the life of the plan – 36 months below-median, 60 months above-median. Interest does not accrue on priority unsecured tax claims during the plan unless the plan provides otherwise. Penalties on priority tax are treated as general unsecured debt and discharged at the end of the plan along with credit card debt.

For a client with $30,000 in recent income tax and $40,000 in credit card debt, the practical Chapter 13 result is often $30,000 paid in full over 60 months at about $500/month, the credit card debt and tax penalties discharged at the end. The interest and penalty meter stops the day the petition is filed. See our Chapter 13 page.

Common Mistakes

• Filing bankruptcy too soon after the three-year, two-year, or 240-day periods (an extra month often makes the difference)
• Failing to file old tax returns before the bankruptcy (un-filed returns block discharge of the underlying tax)
• Not getting an IRS account transcript to verify the assessment dates and filing history
• Filing after a recorded NFTL when timing could have avoided the lien
• Filing when the CSED is months away and the case would simply toll the clock
• Failing to account for offer-in-compromise tolling when computing the three-year and 240-day periods

Schedule a Consultation

Tax debt cases reward careful preparation. Call 786-522-1411 or email [email protected]. We will pull IRS account transcripts, run the timing analysis, and tell you exactly what relief is realistic.