Overview

When you face serious tax debt, two common options are an IRS installment agreement (a payment plan) or filing for bankruptcy. Each option has different eligibility rules, costs, effects on assets and credit, and long-term outcomes. This article explains how each works, the legal tests that matter (especially for tax discharge in bankruptcy), and a practical decision checklist you can use when weighing the two.

Quick comparison

  • Installment agreement: keeps you out of court, lets you pay over time, and typically preserves credit if you remain current. The IRS charges interest and late-payment penalties; in many cases it will stop aggressive collection while the plan is current (IRS: Installment Agreements).
  • Bankruptcy: a federal court procedure (Chapter 7 or Chapter 13 most commonly) that can eliminate or restructure debts. Only certain tax debts qualify for discharge, and bankruptcy has a substantial credit and collateral impact (IRS: Chapter 7; IRS: Chapter 13).

Sources: IRS—Installment Agreements (https://www.irs.gov/payments/installment-agreements), IRS—Chapter 7 (https://www.irs.gov/filing/chapter-7-liquidation-bankruptcy), IRS—Chapter 13 (https://www.irs.gov/filing/chapter-13-repayment-plan-bankruptcy).

When can tax debt be discharged in bankruptcy?

Income tax debts are not automatically dischargeable. For a typical income tax liability to be discharged in a Chapter 7 case, three statutory tests generally must be met (11 U.S.C. §523(a)(1); see IRS guidance):

  1. The tax return’s due date (including extensions) was at least three years before you file bankruptcy.
  2. The tax return was actually filed at least two years before the bankruptcy filing date.
  3. The tax was assessed by the IRS at least 240 days before the bankruptcy filing (these 240 days can be extended or tolled in some circumstances, e.g., when collection is suspended).

Additionally, taxes resulting from fraud, willful evasion, trust-fund taxes (like payroll withholding that an employer failed to remit), and many penalties are nondischargeable. In Chapter 13, you usually repay priority tax claims through a plan rather than receive an immediate discharge for them (IRS: Discharge of Tax Debt—see www.irs.gov).

Note: These rules are nuanced. In my practice I’ve seen clients assume old taxes will vanish in Chapter 7 only to learn a returned-not-filed or recently assessed tax still blocks discharge. Consult a bankruptcy attorney and tax advisor before relying on discharge timing.

Installment agreements: eligibility, cost, and process

  • Eligibility: Most taxpayers can request an installment agreement. Short-term and streamlined plans exist for smaller balances; larger balances or partial-payment requests require financial disclosure (Forms 9465 and often a financial statement like Form 433-F).
  • How to apply: You can request plans online, by phone, or on Form 9465. For complex or partial-payment plans the IRS will review detailed income, expense, and asset information.
  • Cost: Installment agreements carry interest (the federal short-term rate plus 3%) and a late-payment penalty (0.5% per month), as well as an agreement setup or user fee for some online/direct-debit plans. A direct debit installment agreement (DDIA) often lowers setup costs and reduces default risk.
  • Collection stay: While the plan is current the IRS will generally suspend enforced collection (levies, seizures), though the IRS can require certain safeguards like liens.

Practical note: In my experience a Direct Debit Installment Agreement reduces accidental defaults because payments come out automatically; see FinHelp’s guide on setting up installment plans for step-by-step help (internal resource: “Installment Agreements Explained: Types, Qualifications, and Costs” – https://finhelp.io/glossary/installment-agreements-explained-types-qualifications-and-costs/).

Bankruptcy: what it can (and can’t) do for tax debt

  • Chapter 7: Means-tested liquidation bankruptcy can discharge certain older income tax debts if the statutory timing tests are met and the returns were properly filed.
  • Chapter 13: Creates a 3–5 year repayment plan. It can allow you to pay nondischargeable tax priority claims through the plan over time and may reduce non-priority unsecured claims. Chapter 13 can be preferable if you want to keep secured property (home) and reorganize tax liabilities (IRS: Chapter 7; IRS: Chapter 13).

Bankruptcy also triggers an automatic stay that halts most collections immediately upon filing. However, an IRS tax lien is not erased by discharge; discharge eliminates the personal liability for the tax, but the lien can survive and must be specially addressed (often through lien release procedures or lien avoidance in Chapter 13/11). For more on interaction between bankruptcy and tax liens see FinHelp’s coverage: “How Bankruptcy Impacts Federal Tax Debt: Discharge vs Non-Discharge” (https://finhelp.io/glossary/how-bankruptcy-impacts-federal-tax-debt-discharge-vs-non-discharge/).

Effects on credit and assets

  • Credit score: Installment agreements have limited direct impact if you stay current; bankruptcy (Chapter 7 or 13) produces a major negative credit event—Chapter 7 stays on a credit report up to 10 years, Chapter 13 up to 7 years.
  • Assets and exemptions: Chapter 7 can put nonexempt assets at risk to pay creditors. State exemptions vary, so a bankruptcy attorney can explain what you can protect. Chapter 13 usually protects assets by funding a repayment plan.

How to decide: a practical checklist

Use this checklist to compare the two options before you act:

  1. What portion of your debt is tax-related? If taxes are a small share of otherwise manageable debts, an installment plan is often simpler.
  2. How old are the tax liabilities and returns? If the returns are older than the statutory thresholds and properly filed, bankruptcy discharge might be possible—otherwise it likely won’t help.
  3. Do you have wage garnishments, levies, or enforced collection now? An installment plan can stop levies if accepted and current; bankruptcy immediately stops most collection activity.
  4. Can you afford reasonable installment payments? If so, a plan avoids bankruptcy’s long-term credit hit.
  5. Are there other overwhelming debts (medical, credit cards) or a need to restructure secured debts like a mortgage? Bankruptcy may provide broader relief.
  6. Are payroll (trust fund) taxes or fraud penalties involved? These are generally nondischargeable and should be handled differently.

If you answer yes to multiple items that point toward systemic insolvency (large unsecured debts, inability to meet monthly expenses, risk of losing a home), bankruptcy deserves priority consideration. If your problem is primarily an unpaid tax balance but income and cash flow make monthly payments possible, start with an installment agreement or negotiate an Offer in Compromise if eligible.

Real-world examples (illustrative)

  • Installment agreement: A seasonal business owner with $12,000 owed chose a 48-month Direct Debit Installment Agreement. She remained compliant, avoided seizure, and kept credit intact while rebuilding cash flow.
  • Bankruptcy: A household with $150,000 in unsecured debt and $35,000 in older taxes qualified for Chapter 7. Because some taxes met the timing tests and returns had been filed, the bankruptcy eliminated certain personal tax liabilities; liens required separate resolution.

Professional tips

  • Document everything: save tax notices, proof of filing, and any IRS correspondence. Timing rules turn on exact filing and assessment dates.
  • If you file bankruptcy, tell your tax professional and provide schedules to avoid missed tax filings that could later make taxes nondischargeable.
  • Consider a partial-payment installment agreement only after preparing a complete financial statement—this improves your credibility with the IRS.
  • Before filing bankruptcy, inquire about how to handle state tax claims and tax liens—state taxes follow different rules and may behave differently in bankruptcy.

Common mistakes to avoid

  • Assuming all taxes are dischargeable. Recent returns, unfiled returns, fraud, and trust-fund taxes often survive bankruptcy.
  • Missing payments under an installment plan. Defaults can result in revoked agreements and renewed collection actions.
  • Waiting too long to file for bankruptcy when facing imminent foreclosure, wage garnishment, or multiple creditor lawsuits. An early filing can preserve assets and stop collections.

How to start: practical steps

  1. Gather tax returns, IRS notices, assessment dates, and income/expense records.
  2. Talk to a tax attorney or certified tax professional about discharge tests and installment options. If bankruptcy looks possible, consult a bankruptcy attorney.
  3. If you can pay monthly, apply for an IRS installment agreement online or by submitting Form 9465 and required financial statements.
  4. If filing bankruptcy, file the necessary schedules, attend the 341 meeting, and disclose tax debts accurately.

For additional reading on installment plan types and setup, see FinHelp’s guide: “Installment Agreements Explained: Types, Qualifications, and Costs” (https://finhelp.io/glossary/installment-agreements-explained-types-qualifications-and-costs/). For details on how bankruptcy impacts federal tax debt and liens, see: “How Bankruptcy Impacts Federal Tax Debt: Discharge vs Non-Discharge” (https://finhelp.io/glossary/how-bankruptcy-impacts-federal-tax-debt-discharge-vs-non-discharge/). Also review FinHelp’s article on how bankruptcy and installment agreements interact for planning nuances: “How Bankruptcy Interacts with IRS Installment Agreements” (https://finhelp.io/glossary/how-bankruptcy-interacts-with-irs-installment-agreements/).

Useful official resources

Final thoughts and disclaimer

Choosing between an IRS installment agreement and bankruptcy is a fact-specific decision that turns on the age and type of tax debt, your overall financial picture, and your long-term goals. In my practice I advise clients to document assessment and filing dates carefully and seek both a qualified tax professional and, if bankruptcy is a possibility, a bankruptcy attorney licensed in their state. This article is educational and not a substitute for personalized legal or tax advice. Contact a licensed professional before taking action.