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Does bankruptcy clear debt?

Can filing for Bankruptcy wipe out my tax debt?

Filing for Bankruptcy can be an excellent tool to address tax debts as well as other debts but it is very important to talk to a local Bankruptcy Attorney before making any final decisions.

Laws vary by State and Bankruptcy District

As Bankruptcy courts are Federal courts the country is divided into Bankruptcy Districts. The specific rules for a bankruptcy do vary from California to Texas to New York. This is why you need to talk to a Bankruptcy Attorney where you live to see what the specific rules are where you live and how that will affect your case in particular.

In general, Bankruptcy can eliminate (or discharge) most debt such as: consumer debt (credit cards), medical bills, personal loans, vehicle loans, etc. There are a few exceptions that cannot be discharged in bankruptcy. 

here are different types of bankruptcy and which type you might qualify for will depend on your financial situation. These rules again vary by Bankruptcy District.

What types of debt cannot be discharged in Bankruptcy?

Tax debt that has been assessed less than two (2) years normally cannot be discharged in a bankruptcy case. This can cause a lot of problems as you have to be current with all of your tax filings as part of the bankruptcy proceedings. This means a lot of people have to file tax returns as they prepare to file for bankruptcy but these recent filings will not be included in the bankruptcy. 

  • Be aware – the two years starts after the debt is assessed, or shortly after a return is filed and processed, NOT the tax year of the return. For example if a 2018 tax return was filed in 2023 it would not be older than two years until 2025.

Other types of debt that usually are not dischargeable in bankruptcy are:

  • Student loans
  • Business government loans, such as PPP loans, SBA loans, EIDL loans
  • Mortgage debt – if you are keeping the home.

This list is not exhaustive and for this reason it is very important to review the specifics of your case with a local Bankruptcy Attorney.

Filing for Bankruptcy STOPS all IRS and state collection actions while you are in bankruptcy. This means you can focus on the bankruptcy and deal with your tax debts later. BUT, filing for bankruptcy can cause problems too if you need to resolve your tax case as no action can be taken on your tax case while a bankruptcy is active. Some examples are:

  • If your passport is suspended and you need it reinstated. You will not be able to get it reinstated until after the bankruptcy is done.
  • You need to sell/refinance or buy property.
  • A lock-in Letter has been filed to lock in your withholdings to singe and zero.
  • You need a tax lien removed.

It is important to discuss your case with a Tax Professional prior to filing for bankruptcy to see if that is really the best way for you.

Is Bankruptcy the best option?

If most of your debt is tax debt there are ways to address your tax debt without filing for bankruptcy. Many of these options can repair your credit, allow for the purchase or sale of real property and help you accomplish what you want.

If most of your debt is not tax debt or you have creditors threatening you with seizure Bankruptcy might be the better option. In rare cases filing for bankruptcy when your debt is just tax debt might be the best option. This is usually the case in extreme cases where a taxpayer has dodged the IRS/State for many years and the IRS/State is ready to hit the taxpayer hard. 

One real life example is where the IRS was ready to seize all of the cars on a taxpayer’s car lot. The taxpayer had ignored the IRS to the point the order to seize all of the vehicles was coming at any moment. The only way to protect him was to file a business bankruptcy – which was very expensive in his case!

In Summary,

Filing for Bankruptcy might be the best option for you but timing can be everything. It might be better to deal with your tax issues and then when two years have passed file for Bankruptcy, or file for Bankruptcy then deal with any leftover taxes.

Make sure to do your homework first by talking to a local Bankruptcy Attorney and a Tax Professional. The different perspectives and expert knowledge is different and can help steer you to the path that is best for you. Good advice can be priceless and can not only save you a lot of headaches but help you reach your long term financial goals.

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