When to Use Bankruptcy as a Tax Debt Strategy

When should you consider bankruptcy for tax debt?

Facing large unpaid tax bills can feel like an emergency. Bankruptcy is a legitimate tool for some taxpayers, but it isn’t a catch‑all. This article explains when bankruptcy can be an effective tax‑debt strategy, the legal tests the courts use, how Chapter 7 and Chapter 13 differ for taxes, what taxes are not dischargeable, and practical steps to evaluate your options.

How bankruptcy interacts with tax debt: the basics

Bankruptcy can do two things for tax debt:

• Remove personal liability for certain old income taxes (a discharge).
• Create breathing room through the automatic stay and, in Chapter 13, a structured repayment plan.

However, a bankruptcy discharge does not automatically erase every tax debt, nor does it always remove IRS liens on property. The key is timing and the nature of the tax debt.

(Authoritative overview: see IRS guidance and U.S. Courts explanations on taxes and bankruptcy: https://www.irs.gov and https://www.uscourts.gov.)

The four discharge tests for income tax (what courts look for)

Most bankruptcy practitioners and courts apply a set of timing and conduct tests before allowing an income tax to be discharged. Simplified, they are:

1. Return due date test: the tax return’s due date (including extensions) must be at least three years before you file bankruptcy.
2. Filing test: the tax return was actually filed at least two years before the bankruptcy filing date.
3. Assessment/240‑day rule: the IRS assessed the tax (formally entered it on its books) at least 240 days before you filed bankruptcy. This period can be extended for suspended collection or criminal investigations.
4. No fraud/willful evasion: the tax was not the result of fraud, false return, or willful evasion.

These rules come from 11 U.S.C. §523(a)(1) and common interpretations used by bankruptcy courts (U.S. Courts; IRS guidance). In my practice I always run these four tests first because missing a single test usually makes the tax nondischargeable.

Which taxes are normally nondischargeable

• Trust‑fund and payroll taxes (withheld employee income taxes and FICA) are almost always nondischargeable.
• Fraudulent tax liabilities and penalties tied to willful evasion are nondischargeable.
• Recent income taxes (failing the three‑year/ two‑year/240‑day tests) are not dischargeable.

The IRS and many courts treat “trust fund” or payroll taxes as a separate, high‑priority liability because the employer collected them from employees. See IRS guidance on trust fund recovery and collection.

Chapter 7 vs Chapter 13: how each handles tax debt

• Chapter 7 (liquidation): If the discharge rules are met, qualifying older income taxes can be wiped out along with other unsecured debts. But Chapter 7 does not normally remove an existing IRS tax lien. The discharge eliminates your personal liability, but the lien can remain attached to property until released or satisfied.

• Chapter 13 (repayment plan): Chapter 13 does not typically “discharge” priority tax debt up front, but it allows you to repay tax liabilities over a 3–5 year plan. Certain older income tax liabilities that would meet the discharge tests may still be wiped out at the end of a successful Chapter 13 plan. Chapter 13 can be useful when you need to keep property or want to catch up on tax liens and secured debt.

In my experience helping clients, Chapter 13 is often the practical choice if they have valuable assets they want to protect while paying the IRS on manageable terms.

Tax liens, refunds, and the automatic stay

• Automatic stay: Filing bankruptcy triggers an automatic stay that halts most IRS collection actions (levies, garnishments) while the case proceeds. There are exceptions and complex interactions if criminal or administrative proceedings are underway (U.S. Courts).

• Tax liens: A bankruptcy discharge generally removes the taxpayer’s personal liability for dischargeable taxes but does not automatically remove an IRS tax lien that was recorded before the bankruptcy. To remove a lien you generally need to pay it, reach a separate agreement, or in some limited cases avoid it in Chapter 13 or under lien-avoidance doctrines.

• Refunds: If you are entitled to a tax refund, the timing matters. A refund that becomes property of the bankruptcy estate may be used to pay creditors if the return is filed before the bankruptcy case concludes.

Practical eligibility checklist (quick screening)

• Have you filed all required tax returns? (If not, filing them is usually step one.)
• Is the taxable year at least three years before your planned bankruptcy filing date (return due date including extensions)?
• Was the return actually filed at least two years before filing bankruptcy?
• Was the tax assessed at least 240 days before bankruptcy?
• Is there any allegation of fraud, false return, or intentional evasion?
• Are any payroll/trust fund taxes involved?

If you answer “no” to any of the timing or fraud tests for the taxes in question, that tax likely cannot be discharged.

When bankruptcy often makes sense (realistic scenarios)

• Old income taxes that pass the timing tests, you have limited nonexempt assets, and you want a fresh start — Chapter 7 can be effective.
• Ongoing collection actions and the need to keep a home or business — Chapter 13’s repayment schedule can reorganize payments and stop levies while protecting property.
• Complex estates with liens where a Chapter 13 plan provides a structured way to pay priority taxes without liquidating valuable assets.

Example (from practice): I worked with a client who had multiple tax years older than the three‑year window and minimal assets. Chapter 7 cleared the qualifying tax liabilities and allowed the client to rebuild financially. Conversely, another small business owner kept the business afloat by using Chapter 13 to repay back payroll taxes and past income taxes over five years while keeping key equipment.

Alternatives to bankruptcy (compare before filing)

• Installment Agreement (IRS): Often the first-line option to pay over time.
• Offer in Compromise (OIC): May settle the liability for less than the full amount if you meet stringent criteria — see our guide “When to Consider an Offer in Compromise vs Bankruptcy for Tax Debt” for a side‑by‑side comparison: When to Consider an Offer in Compromise vs Bankruptcy for Tax Debt.
• Currently Not Collectible status and penalty abatement in limited situations.
• Voluntary collection holds or negotiated extensions — sometimes preferable to bankruptcy’s credit consequences.

For more on alternatives, read our overview: Alternatives to Bankruptcy for Resolving Large Tax Debts.

Common mistakes and pitfalls to avoid

• Filing bankruptcy before filing required tax returns. Courts often deny discharge if returns are missing.
• Assuming tax liens vanish after discharge — they usually remain attached to property.
• Using bankruptcy to escape payroll/trust‑fund taxes or fraud penalties — these are generally nondischargeable.
• Transferring assets before filing. Transfers made to hide assets or reduce the estate can be reversed and may lead to denial of discharge.

Step-by-step practical approach (what I recommend)

1. Gather tax notices, returns, and IRS account transcripts for the last six years.
2. Confirm filing dates and assessment dates to run the four discharge tests above.
3. Consult a bankruptcy attorney who regularly handles tax matters (in my practice, I refer to a local tax‑bankruptcy specialist when needed).
4. Consider non‑bankruptcy resolutions (installment agreement, OIC) if you have options to settle without the long credit impact.
5. If bankruptcy appears the best route, coordinate timing: filing too early can make taxes nondischargeable; filing too late may cost additional interest and penalties.

How bankruptcy affects credit and long‑term planning

A bankruptcy remains on credit reports (Chapter 7 for up to 10 years; Chapter 13 for up to 7 years) and will affect loan access and interest rates. But for many clients, resolving crippling tax debt and stopping IRS collections produces a net long‑term financial benefit. After discharge, rebuilding credit and staying current on taxes are essential.

Further reading and internal resources

• When Bankruptcy Affects Tax Debts: Priority, Discharge, and Collection Actions: https://finhelp.io/glossary/when-bankruptcy-affects-tax-debts-priority-discharge-and-collection-actions/
• When to Consider an Offer in Compromise vs Bankruptcy for Tax Debt: https://finhelp.io/glossary/when-to-consider-an-offer-in-compromise-vs-bankruptcy-for-tax-debt/
• Alternatives to Bankruptcy for Resolving Large Tax Debts: https://finhelp.io/glossary/alternatives-to-bankruptcy-for-resolving-large-tax-debts/

Final checklist before deciding

• Have you run the four discharge tests for each tax year?
• Are payroll or trust‑fund taxes involved?
• Have you filed all required returns and collected IRS transcripts?
• Have you consulted a bankruptcy attorney with tax expertise?

If you can answer yes to the first three and an attorney confirms bankruptcy is appropriate, it can be a powerful tool to stop collections and obtain relief on qualifying taxes.

Disclaimer: This article is educational and does not constitute legal or tax advice. For personalized guidance, consult a licensed bankruptcy attorney or tax professional. Authoritative sources used: U.S. Courts (bankruptcy basics and taxes) and the Internal Revenue Service (bankruptcy and collection guidance).