Handling Back Taxes During Bankruptcy: What Stays and What Goes

Overview

Bankruptcy can be a powerful tool to stop collections and in some cases eliminate old income tax debts. But tax law and bankruptcy law overlap in complex ways: some taxes are dischargeable under Chapter 7 or may be repaid under Chapter 13, while others—like payroll withholding (trust‑fund) taxes, fraud penalties, and many penalties—generally are not dischargeable. Even when a tax debt is discharged, the government’s tax lien can survive and continue to attach to property.

Authoritative sources: IRS guidance on bankruptcy and taxes (see https://www.irs.gov/businesses/small-businesses-self-employed/bankruptcy) and U.S. Courts information on taxes and bankruptcy (https://www.uscourts.gov/).

Key rules that determine dischargeability

For individual income tax debts to be discharged in a Chapter 7 case, courts generally apply a set of timing and conduct rules derived from 11 U.S.C. §523(a)(1) and case law. The most commonly cited tests are:

• Return‑due rule (three‑year rule): The tax return for that year must have been due (including extensions) at least three years before you file bankruptcy.
• Return‑filed rule (two‑year rule): The return must have actually been filed at least two years before you file.
• Assessment/240‑day rule: The tax assessment must have been made at least 240 days before the bankruptcy filing, subject to exceptions that can extend this period.
• No fraud and no willful evasion: Taxes tied to fraudulent returns or willful tax evasion are not dischargeable.

These rules are technical; small differences in filing dates, assessments, or tolling events (for example, offers in compromise or pending audits) can change the result. The IRS explains exceptions and timing details on its bankruptcy pages.

Types of tax debts and how they’re treated

• Income taxes (individual and many state income taxes): Potentially dischargeable if the timing rules and filing conditions are met and there is no fraud or willful evasion.
• Trust‑fund or payroll withholding taxes: Generally non‑dischargeable. These are amounts employers withheld from employees (income tax withholdings, FICA) and then failed to remit. The IRS treats some of these amounts as personal liabilities of responsible persons (trust‑fund recovery penalty) that survive bankruptcy.
• Fraudulent or willful evasion taxes: Non‑dischargeable.
• Tax penalties: Many penalties are tied to non‑dischargeable underlying taxes or are themselves non‑dischargeable when based on fraud or willful evasion. Some ordinary civil penalties accompanying dischargeable taxes may be discharged—this depends on the underlying tax being dischargeable and the statute under which the penalty arose.
• Property taxes and local taxes: Treatment varies by jurisdiction. Some unpaid real‑property taxes create liens that survive and are collected through foreclosure or sale; other local taxes may follow federal rules similar to income taxes.

For an actionable breakdown and examples of specific categories, see our glossary pages: “When Bankruptcy Can and Cannot Eliminate Tax Debt” and “How Bankruptcy Affects Federal Tax Debt and Liens.”

(Internal links: When Bankruptcy Can and Cannot Eliminate Tax Debt: https://finhelp.io/glossary/when-bankruptcy-can-and-cannot-eliminate-tax-debt/; How Bankruptcy Affects Federal Tax Debt and Liens: https://finhelp.io/glossary/how-bankruptcy-affects-federal-tax-debt-and-liens/)

Chapter 7 vs. Chapter 13 — main practical differences

• Chapter 7 (liquidation): If your taxes meet the discharge rules, Chapter 7 can eliminate qualifying income tax obligations permanently. The case also triggers an automatic stay that halts most IRS collection actions (levies, garnishments) immediately on filing. However, tax liens generally survive Chapter 7, so discharged tax amounts do not automatically remove liens from property.

• Chapter 13 (repayment plan): You keep property but repay past‑due taxes through a court‑approved repayment plan over 3–5 years. Chapter 13 is often used when taxes are more recent or non‑dischargeable under Chapter 7 timing rules. In Chapter 13, priority tax claims must be paid in full except where the plan treats certain priority claims differently under the Code.

Both chapters stop most IRS collections while the case proceeds via the automatic stay (see U.S. Courts and IRS guidance).

How liens, refunds, and collections are affected

• Tax liens: A federal tax lien attaches when the IRS files a Notice of Federal Tax Lien. Bankruptcy may discharge the taxpayer’s personal liability for the tax, but liens generally survive and remain attached to the property until paid or released. To remove a tax lien, you must pay it, negotiate removal with the IRS, or obtain lien avoidance through the bankruptcy court in limited cases (e.g., if the lien impairs an exemption).

• Tax refunds: Refunds for the year you file bankruptcy and for prior years can become part of the bankruptcy estate and used to pay creditors. Expect your trustee to review pending refunds and possibly apply them to the estate.

• Collections and the automatic stay: Filing a bankruptcy petition immediately triggers an automatic stay that halts most collection actions, including wage garnishments and levies, while the case is pending. The IRS can ask the court for relief from the stay in specific circumstances.

Practical steps to take if you owe taxes and are considering bankruptcy

1. Gather documents: tax returns for the last 3–6 years, IRS transcripts, notices and CP letters, lien filings, proof of payments, payroll tax records, and correspondence with the IRS.
2. Request tax transcripts from the IRS (they show assessments and dates). These dates matter for the 3‑year/2‑year/240‑day rules. See the IRS transcript request page: https://www.irs.gov/individuals/get-transcript.
3. Consult both a bankruptcy attorney and a tax professional before filing. Timing and small facts change outcomes.
4. Consider Chapter 13 if some taxes are recent or you need time to pay. Consider Chapter 7 if old taxes meet the discharge tests.
5. Don’t stop filing returns. Keep filing ongoing tax returns on time; failing to file makes discharge less likely.
6. Evaluate alternatives such as an installment agreement or Offer in Compromise with the IRS. Bankruptcy is not always the best option. See our glossary article on tax debt relief options for alternatives.

Common mistakes and misconceptions

• Believing all tax debt disappears in bankruptcy: Not true. Trust‑fund taxes, fraud‑based taxes, and many penalties survive.
• Relying on discharge to remove liens: Discharge removes personal liability, not all liens. Expect liens to remain unless separately addressed.
• Ignoring timing rules: Missing a filing date, assessment date, or not accounting for tolling can make a discharge impossible.
• Failing to keep records: Transcripts and return copies are often decisive in disputes with the trustee or IRS.

Examples (realistic, anonymized)

• Discharged tax debt example: An individual filed timely returns for 2016–2018. The 2016 tax was assessed in 2019 and more than 240 days before a 2023 bankruptcy filing; the return was filed more than two years earlier and due more than three years earlier. The Chapter 7 trustee did not object and the 2016 tax was discharged.

• Non‑dischargeable example: A small business owner failed to remit payroll withholdings for employee wages. The IRS assessed trust‑fund recovery penalties against the owner in 2021. Those trust‑fund penalties were found to be non‑dischargeable in both Chapter 7 and Chapter 13.

Checklist: Documents to bring to your meeting with a bankruptcy attorney

• Federal and state tax returns (3–6 years)
• IRS tax transcripts (account transcripts and record of assessments)
• Any CP Notices, liens, and collection notices
• Pay stubs and payroll records (if payroll taxes are an issue)
• Bank statements and asset records

FAQs (short answers)

Q: Will bankruptcy stop IRS collection? A: Yes—an automatic stay usually stops most collections while the case is active. The IRS can request relief from the stay. (U.S. Courts)

Q: Can I discharge back taxes if I didn’t file returns? A: Not usually. Timely filing is a core requirement for dischargeable income taxes.

Q: Do tax liens disappear after discharge? A: Generally no. Discharge eliminates personal liability for the tax, but liens typically survive and must be addressed separately.

When to get professional help

If you owe back taxes and are thinking about bankruptcy, contact a bankruptcy attorney and a tax professional. In my 15+ years advising clients, the single biggest value is timing: correct dates and proper documentation frequently determine whether taxes are wiped out or survive. A lawyer can also advise if a Chapter 13 plan or lien‑avoidance motion makes sense.

Final notes and disclaimer

This article explains common rules and practical steps but is educational only. Tax and bankruptcy outcomes depend on specific facts and up‑to‑date law. Consult a licensed bankruptcy attorney and a tax advisor before making decisions. For official IRS guidance, see the IRS’s bankruptcy page: https://www.irs.gov/businesses/small-businesses-self-employed/bankruptcy. For court procedures and forms, visit the U.S. Courts website: https://www.uscourts.gov/.

Related reading on FinHelp:

• When Bankruptcy Can and Cannot Eliminate Tax Debt: https://finhelp.io/glossary/when-bankruptcy-can-and-cannot-eliminate-tax-debt/
• How Bankruptcy Affects Federal Tax Debt and Liens: https://finhelp.io/glossary/how-bankruptcy-affects-federal-tax-debt-and-liens/