The reasons why taxpayers have unpaid tax debts is as varied as the ways that taxpayers earn their incomes. For some, the tax debts result from under-withholding by an employer. For others, tax debts result from not having taxes withheld from income due to the taxpayer being employed as an independent contractor. In many cases, unpaid tax debts result from failed small businesses in which the taxpayer was personally liable. The law provides a number of remedies for resolving these types of tax debts. Discharging all or a portion of the tax debts in bankruptcy may be one such remedy.

Unpaid Tax Debts and Chapter 7 Bankruptcy

Chapter 7 bankruptcy is often referred to as a “liquidation” or “straight bankruptcy.” In a Chapter 7, the taxpayer’s non-exempt assets are sold and the proceeds are paid to the taxpayer’s creditors. The taxpayer may be relieved of personal liability for unpaid debts owed to the taxpayer’s remaining creditors. In other words, these unpaid debts may be discharged in bankruptcy. The taxpayer may or may not be relieved of personal liability for tax debts in this process.

To be relieved of personal liability for unpaid tax debts in Chapter 7, the tax debt must:

1. be for a tax year for which the tax return due date was at least three years prior to the date that the bankruptcy petition is filed,
2. be recorded by the IRS on its books at least 240 days prior to the bankruptcy filing date, and
3. be for a year where the taxpayer filed a tax return at least two years prior to bankruptcy filing date.

There are a whole host of nettlesome rules that can prevent the unwary taxpayer from discharging unpaid tax debts in a Chapter 7 bankruptcy. For our purposes, suffice it to say that the Chapter 7 bankruptcy provides little relief for unpaid tax debts if the taxpayer has any significant non-exempt assets, such as equity in real estate.

A taxpayer may also be precluded from filing Chapter 7 bankruptcy due to the taxpayer having earned too much income and consumer debt (this is referred to as the “means test”). Taxpayers who find themselves in this position may need to consider Chapter 13 bankruptcy in lieu of Chapter 7.

Unpaid Tax Debts and Chapter 13 Bankruptcy

Chapter 13 bankruptcy is often referred to as a “reorganization” or “wage earners plan.” As with the IRS’s Offer in Compromise program, Chapter 13 bankruptcy is a repayment plan.

In a Chapter 13, the taxpayer must propose and fulfill a payment plan whereby priority claims and secured creditors are paid in full. Unpaid tax debts may be priority claims if they are (1) for a tax year in which the tax return due date was less than three years prior to the date that the bankruptcy petition is filed or (2) are not recorded by the IRS on its books at least 240 days prior to the bankruptcy filing date. Unpaid taxes for older tax years are generally treated as unsecured claims.

If the IRS has filed notice of its federal tax lien prior to the date on which the taxpayer filed its Chapter 13 petition, the claim will be secured up to the amount of the tax listed on the IRS notice of federal tax lien. This claim may qualify as a priority claim.

If the tax debt is a non-priority unsecured claim, it may be discharged in the Chapter 13 bankruptcy. In addition to discharging unpaid tax debts that are not priority claims, the taxpayer may be able to avoid paying interest on unsecured tax debts once the Chapter 13 bankruptcy petition is filed. Taxpayers may be inclined to file Chapter 13 bankruptcy to stop the accrual of interest on their unpaid tax debts.

Taxpayers should also be aware that, unlike Chapter 7, there is no “means test” for Chapter 13 bankruptcies. This can often make Chapter 13 the only viable remedy for taxpayers who have disposable income and consumer debts.

The bankruptcy tax laws and procedures are complex and they are constantly changing. The consequences for failing to comply with the tax, bankruptcy, and other rules can have a dramatic impact upon the taxpayer’s financial situation. Taxpayers who have unpaid tax debts or who are thinking about filing bankruptcy should consult with an experienced tax attorney and consider the bankruptcy court procedures.