Thanks to Michael Scott, we all know confidently that shouting “I declare bankruptcy” into the void won’t make your debt problem vanish into thin air. Well, as it turns out, neither does actually declaring bankruptcy.
As long as the IRS is involved, bankruptcy isn’t necessarily a magic eraser (though it can be a solution). It all depends on what you owe, when you filed your returns, and how your case is handled.
Now, bankruptcy can be a powerful tool for alleviating your financial burdens, but the IRS and bankruptcy court rules are stringent. Understanding the right steps to take legally is key to making sure your case isn’t derailed.
In other words, it’s good to have an experienced professional you trust to give you the rundown and help you set proper expectations for the process (wink, wink).
So, let’s go over what happens to your tax debt in bankruptcy.
First, the good news — Some of your federal income tax debt can be discharged in bankruptcy if you meet the IRS’s strict requirements for this — often referred to as the 3-2-240 Rule. Basically, you won’t get your tax debt cleared unless…
- The return for the tax debt was due at least 3 years ago.
- You actually filed that return at least 2 years ago.
- The IRS assessed the tax at least 240 days ago.
But, even if you meet these time rules, if you filed that return late or if there was any fraud involved, that debt usually isn’t going anywhere. For instance, if you filed your 2020 return late in 2023, it likely won’t qualify for discharge until late this year (2025). That’s a key detail many tax software programs and tax resolution companies gloss over.
Now for the not-so-good news. Some tax debts in bankruptcy are practically cemented in place, meaning they’re almost always nondischargeable:
- Payroll (trust fund) taxes: These are the IRS’s top priority because they were withheld from employee wages — like money held in trust for the government.
- Fraud penalties: If your tax debt is tied to intentional wrongdoing, that’s not getting discharged.
- Recent income taxes: If the return was due within the last 3 years, it’s generally sticking around.
Even if you file for Chapter 13 bankruptcy, which allows you to set up a repayment plan, these debts could potentially survive unless you pay them in full during the plan. Knowing which debts may stick around ahead of time means you can build a realistic plan, often with breathing room you didn’t know was possible.
Another crucial caveat to be aware of: tax debt in bankruptcy can eat up your returns. In Chapter 7 bankruptcy specifically, your refund can be seized as part of your bankruptcy estate and used to pay your creditors. In Chapter 13, the court may also redirect future refunds to creditors through your repayment plan. With good planning, of course, you can account for these seizures and keep them from surprising you.
One more important detail– if you discharge your tax debt in bankruptcy, it doesn’t remove existing tax liens on your property.
Even though you’re personally free of the debt, the IRS lien survives the bankruptcy and can still attach to your property, like your home, until that property is sold or refinanced. The IRS still gets paid from the sale proceeds. It’s a critical distinction that can have long-term financial consequences.
All of this is assuming that you will be able to successfully file for bankruptcy in the first place, of course. It’s definitely not as easy as Michael Scott wanted it to be. If you file for bankruptcy, you have two big rules to abide by:
- You must have filed all required tax returns for the past four years.
- You must stay current on new tax filings and payments during the case.
Fail to comply, and your bankruptcy case could be dismissed, leaving you right back where you started with the IRS breathing down your neck.
Bankruptcy can be a powerful tool for a fresh start, and for some, it’s the only viable option. It’s not a magic wand—but it can absolutely provide freedom, especially if you go in with your eyes open and your tax strategy aligned. The key? A solid plan.
Before you even think about signing those bankruptcy papers, let’s sit down and review your entire tax picture. We’ll figure out which debts can truly be wiped out, which need to be handled in a repayment plan, and whether bankruptcy is even the right move for you. And of course, instead of just reacting to debt, let’s get you set up to avoid it altogether.
We’ve helped plenty of Westchester County people in your same situation. And we can help you too:calendly.com/l-karam/prospect-schedule
Here to declare you tax-problem free,
Lynn Karam