When Bankruptcy Affects Tax Debts: Priority, Discharge, and Collection Actions

Quick overview

Filing bankruptcy creates an automatic stay that pauses most collection activity. But not all tax liabilities are treated the same. The court and the IRS classify taxes by priority and dischargeability. Some taxes remain collectible after bankruptcy; others can be included in a repayment plan (Chapter 13) or discharged entirely (in narrow circumstances). My practice shows that correct timing, complete documentation, and early coordination with a tax attorney or CPA materially change outcomes.

How the automatic stay interacts with tax collection

When you file bankruptcy, the court issues an automatic stay that halts many collection actions, including most levies, garnishments, and late-payment notices. The stay gives breathing room to organize claims and determine which tax debts are secured, priority, or nondischargeable. Note: the IRS can ask the bankruptcy court to lift the stay in certain situations (11 U.S.C. §362), and some enforcement actions can resume once the stay is lifted or the case ends.

Source: IRS guidance on bankruptcy and taxes (IRS.gov).

Which tax debts are typically priority or nondischargeable?

Priority taxes are senior claims that generally must be paid in full through a bankruptcy case. Common categories:

• Recent income taxes (often treated as priority if they meet the statutory tests).
• Trust fund or payroll taxes and penalties related to withheld employee taxes — these are almost always non-dischargeable and carry high priority.
• Certain tax penalties tied to fraud or willful evasion are nondischargeable.
• Property tax liens and secured taxes are secured claims and survive the bankruptcy unless the lien is avoided in a separate action.

Practical note from my cases: payroll (trust-fund) taxes are the most problematic in bankruptcy because the IRS prioritizes collection of withheld employee taxes to protect employees and the government’s interest.

When can income taxes be discharged? The common timing tests

Discharging income tax in bankruptcy is possible but depends on a set of timing and filing rules that courts and the IRS apply. Courts commonly look to a cluster of tests drawn from 11 U.S.C. §523(a)(1):

1. The “three-year rule”: the tax return’s due date (including extensions) must have been at least three years before the bankruptcy filing date.
2. The “two-year/filing rule”: the return must have been actually filed at least two years before the bankruptcy filing (many practitioners state the return must have been filed at least two years prior, but courts evaluate the specific circumstances).
3. The “240-day rule”: the tax must have been assessed at least 240 days before the bankruptcy filing (subject to exceptions for IRS collection delays).
4. No fraud or willful tax evasion: if the return was fraudulent or deliberately false, discharge is typically denied.

These rules are technical and courts interpret them case-by-case. The IRS publishes general information for taxpayers in bankruptcy; national bankruptcy practice guides and the American Bar Association provide case law summaries (see sources below).

Sources: IRS—Tax information for individuals in bankruptcy; American Bar Association guidance on bankruptcy and taxes.

Chapter 7 vs Chapter 13: different results for tax debts

• Chapter 7 (liquidation): The trustee liquidates nonexempt assets to pay creditors. Dischargeable qualifying income taxes may be wiped out, but priority taxes and nondischargeable taxes (e.g., recent income taxes, payroll taxes, fraud penalties) survive and remain collectible after the case.

• Chapter 13 (repayment plan): You propose a 3–5 year repayment plan to satisfy priority claims and a portion of unsecured debts. Priority taxes must be paid in full through the plan. Chapter 13 can allow you to stretch tax payments and keep assets while addressing tax liens and negotiated treatment.

In my experience, Chapter 13 is a better fit when you have recent priority tax debts but steady income and want to avoid IRS enforced collection while paying over time.

Tax liens, refunds, and secured claims

• Tax liens: Tax authorities frequently place liens (federal tax liens) on property. Filing bankruptcy does not automatically remove a tax lien: liens are secured interests that survive the discharge unless you successfully avoid them under narrow bankruptcy rules. If you want lien avoidance or redemption, separate motions are often required.

• Tax refunds: Refunds that become payable to a debtor and are received during a bankruptcy case may be property of the bankruptcy estate and could be used to pay creditors. Timely filing of current-year returns and coordination with the trustee are essential.

Internal resource: For a deeper walkthrough of liens and refunds, see our guide on how bankruptcy affects tax debts, liens, and refunds.

Link: How Bankruptcy Affects Tax Debts, Liens, and Refunds

Common tax categories that usually cannot be discharged

• Payroll taxes/Trust fund taxes (employment taxes withheld from employees): generally nondischargeable.
• Fraudulent tax liabilities and those arising from willful evasion.
• Certain trust fund recovery penalties assessed against responsible individuals.
• Excise and some transfer taxes may also be non-dischargeable depending on the facts.

These categories come up repeatedly in my practice: clients often assume all old tax bills vanish in bankruptcy, but trust-fund taxes and fraud-based penalties are almost always excluded.

Practical steps to prepare before filing

1. Collect and organize tax returns for the last 3–6 years, IRS notices, proof of assessments, and correspondence. The bankruptcy trustee and the court will expect documentation. Keeping clean records materially improves results.
2. Confirm whether outstanding returns were filed and when. Unfiled returns almost always block discharge. The IRS and courts look unfavorably on unfiled or late-filed returns.
3. Evaluate whether Chapter 7 or Chapter 13 fits your goals: liquidation vs structured repayment. In many cases with significant priority taxes Chapter 13 lets you pay over time without losing property.
4. Consider alternatives and negotiated options: Offers in Compromise and installment agreements sometimes outperform bankruptcy for tax resolution when eligibility exists. Read our comparison: “When to Consider an Offer in Compromise vs Bankruptcy for Tax Debt.”

Link: Offer in Compromise vs Bankruptcy for Tax Debt

5. Work with professionals: a bankruptcy attorney who knows tax law and a CPA will reduce mistakes and improve your odds of a favorable treatment.

Real-world examples (patterns from practice)

• Example 1: I helped a client with older, non-fraud income taxes where the returns had been filed years earlier and assessments were old. After filing Chapter 7, the qualifying tax liabilities were discharged, and priority trust-fund liabilities remained for collection.

• Example 2: Another client with a large recent assessment and unfiled returns could not discharge those liabilities in Chapter 7; we instead negotiated an installment agreement with the IRS after filing Chapter 13 to stop aggressive collection.

These examples show timing and compliance (filing returns on time and avoiding fraud) are key to what bankruptcy will accomplish.

Mistakes to avoid

• Assuming every tax bill will disappear. Only specific tax debts meeting statutory tests qualify for discharge.
• Failing to file required tax returns before filing bankruptcy. Unfiled returns frequently block discharge and complicate proceedings.
• Ignoring tax refunds. Current-year refunds may be property of the estate and can be used to satisfy creditors.

When the IRS continues collection after bankruptcy

If taxes are nondischargeable or the IRS successfully obtains relief from the stay, collection actions (levies, wage garnishment) can continue or resume. Also, tax liens can be foreclosed even after discharge unless the lien is avoided or paid.

Additional resources and authoritative sources

• IRS: Tax Information for Individuals in Bankruptcy — https://www.irs.gov/businesses/small-businesses-self-employed/tax-information-for-individuals-in-bankruptcy
• American Bar Association — Bankruptcy and Taxes overview.
• Nolo: Bankruptcy and Tax Debts guide.

What I recommend (practical checklist)

• Immediately gather the last 3–6 years of tax returns and IRS notices.
• Consult a tax attorney or bankruptcy attorney before filing; small timing differences change dischargeability.
• Consider Chapter 13 if you need to repay priority taxes over time and protect property.
• Explore offers in compromise or installment agreements as alternative or complementary options.

Disclaimer

This article is educational only and does not create an attorney-client or tax advisor relationship. Bankruptcy and tax laws are fact-specific and change over time. Consult a qualified bankruptcy attorney or tax professional for tailored advice.

Related reading on FinHelp

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

Authoritative sources and further reading: IRS, American Bar Association, Nolo.