Overview

Facing tax debt raises two central questions: can the debt be eliminated, and if not, what protection can a bankruptcy filing provide? Bankruptcy is a powerful tool but it is not a universal fix for taxes. This article explains the differences between Chapter 7 and Chapter 13 for tax debts, the key dischargeability tests, how liens and refunds are treated, and practical steps to evaluate whether bankruptcy is the right path.

How tax debts are treated in bankruptcy

Federal and state tax debts are not all treated the same. Several common rules apply:

  • Income tax debts may be dischargeable under narrow conditions (see the tests below). (IRS, Bankruptcy and Tax Information: https://www.irs.gov/businesses/small-businesses-self-employed/bankruptcy)
  • Trust fund/paye-roll taxes (e.g., withheld income and payroll taxes) and certain penalties are usually nondischargeable.
  • Tax liens generally survive bankruptcy and can remain attached to property even if the tax debt itself is discharged.
  • Filing bankruptcy triggers an automatic stay that temporarily halts most collection actions, including levies and garnishments, but collections tied to nondischargeable taxes may resume if the stay ends or the debt survives.

These points are summarized and updated by the IRS and the Consumer Financial Protection Bureau (CFPB). See IRS guidance on bankruptcy and taxes and CFPB overviews on how bankruptcy affects debt collection (IRS; CFPB: https://www.consumerfinance.gov/consumer-tools/bankruptcy/).

The dischargeability test for income taxes (the 3-year/2-year/240-day rules)

To discharge an income tax in bankruptcy, the tax must generally meet all of the following conditions:

  1. The tax return was due at least three years before you filed bankruptcy (this usually means the tax year’s return due date — including extensions — was at least three years earlier).
  2. The tax return was actually filed at least two years before the bankruptcy filing.
  3. The tax was assessed by the IRS at least 240 days before the bankruptcy filing.
  4. The tax return was not false, fraudulent, and you did not attempt to evade the tax.

These are the basic federal tests most courts apply. If any of the conditions fail, that tax will likely be nondischargeable. For more detail, consult the IRS page on bankruptcy and taxes and speak with a bankruptcy attorney.

Chapter 7: liquidation and when it can help with tax debt

Chapter 7 can discharge qualifying income tax debts if the discharge tests (above) are met. Key points:

  • Who it fits: Individuals whose income passes or is low enough under the means test to qualify for Chapter 7 and who lack significant nonexempt assets.
  • What it can do: Discharge qualifying income taxes and unsecured consumer debts. It provides a relatively fast outcome (typically 4–6 months from filing to discharge) for eligible filers.
  • What it doesn’t do: It generally cannot discharge recent income taxes, payroll/trust fund taxes, or tax penalties tied to fraud or willful evasion. Tax liens on real property usually survive and remain attached to the property.
  • Practical impact: If most tax liabilities meet the discharge tests, Chapter 7 may wipe out those amounts. But if you have significant equity in nonexempt assets, a trustee could sell those assets to pay creditors.

Example (anonymized): In my practice I saw a sole proprietor with older, unfiled income taxes who filed returns, waited the required timing, and then used Chapter 7 to discharge qualifying income taxes. The plan worked because the client had little nonexempt property and met the discharge tests.

Chapter 13: repayment and when it may be better for tax debts

Chapter 13 reorganizes debts into a repayment plan that lasts three to five years. It’s frequently the better option for tax debts if Chapter 7 is unavailable or if liens and secured taxes must be handled differently.

  • Who it fits: Debtors with regular income who cannot pass the Chapter 7 means test or who want to keep property with equity subject to a tax lien.
  • What it can do: Consolidate secured and unsecured debts into a single monthly payment. Chapter 13 can stretch out non-dischargeable priority tax debts over time and may give you a workable repayment schedule where the IRS previously demanded immediate payment.
  • What it doesn’t do: It does not make nondischargeable trust fund taxes disappear. Tax liens generally still attach to real estate until satisfied.
  • Practical advantages: Chapter 13 can strip junior liens in certain circumstances, and it often gives more flexibility to handle back taxes while protecting assets.

Example (anonymized): I helped a homeowner with substantial tax debt but strong monthly income choose Chapter 13. The plan repaid priority taxes through the plan while allowing the client to keep the home and stop garnishments.

How liens, refunds, and levies are affected

  • Liens: Bankruptcy normally does not extinguish federal tax liens. The lien survives and will remain on real estate after a discharge unless the lien is avoided under specific bankruptcy code sections or paid in Chapter 13 plan payments. See our related guide on how bankruptcy affects tax liens: “How Bankruptcy Interacts with Tax Debt: What May Be Discharged” (internal link: https://finhelp.io/glossary/how-bankruptcy-interacts-with-tax-debt-what-may-be-discharged/).
  • Refunds: A tax refund due to you at the time you file bankruptcy usually becomes property of the bankruptcy estate. In Chapter 13, refunds during the plan may be payable to the trustee depending on plan terms. Consult your attorney before filing returns after a filing date.
  • Levies and garnishments: The automatic stay that begins on filing will often stop levies and garnishments immediately, giving breathing room to negotiate. Read more on how the automatic stay interacts with IRS collection actions: “When Bankruptcy Can Stop IRS Collection Actions” (internal link: https://finhelp.io/glossary/when-bankruptcy-can-stop-irs-collection-actions/).

When to consider alternatives before filing bankruptcy

Bankruptcy is not always the best or only option. Consider other routes first:

  • Installment agreements or partial-payment installment agreements with the IRS can spread or reduce payments.
  • Offer in Compromise (OIC) can settle tax debt for less than the full amount if you meet eligibility and can prove doubt as to collectibility or disputes as to liability.
  • Currently Not Collectible (CNC) status may pause collections if you have no ability to pay.

Compare bankruptcy vs IRS relief options before proceeding. Our internal comparison can help: “When to Consider Bankruptcy vs IRS Debt Relief Options” (internal link: https://finhelp.io/glossary/when-to-consider-bankruptcy-vs-irs-debt-relief-options/).

Practical checklist before you file

  1. Gather tax returns for the past 3–6 years and verify filing dates.
  2. Confirm whether any taxes are trust fund or payroll taxes (usually nondischargeable).
  3. Run the Chapter 7 means test to see if you qualify.
  4. Calculate equity in real estate and vehicles (tax liens may remain).
  5. Talk to a bankruptcy attorney who regularly handles tax issues and to your CPA for tax filing timing.
  6. Evaluate offers in compromise, installment agreements, and CNC status as non-bankruptcy options.

Common mistakes and how to avoid them

  • Filing bankruptcy before filing required tax returns. (Many discharges require that returns have been timely filed — if you haven’t filed, the debt may be nondischargeable.)
  • Assuming all taxes are dischargeable. Trust fund and recent taxes, fraud penalties, and some penalties survive bankruptcy.
  • Ignoring liens. Even after a discharge, a tax lien can keep property subject to the government’s claim.
  • Not consulting specialists. Tax law and bankruptcy intersect in ways that require both tax and bankruptcy expertise.

FAQs (short answers)

  • Can payroll taxes be discharged? Generally no. Trust fund taxes (withheld employee taxes) and certain payroll taxes cannot be discharged in bankruptcy.
  • Will Chapter 7 stop the IRS from collecting? Chapter 7 triggers the automatic stay, which stops most collection actions while the case is pending. But nondischargeable taxes and liens can survive and collection may resume after discharge.
  • How long does a Chapter 13 plan last? Three to five years, depending on your income and plan structure.

Sources and further reading

Final considerations and professional note

In my 15+ years advising taxpayers, bankruptcy has saved some clients from ruin when the taxes were old, properly filed, and otherwise dischargeable — but it’s rarely a quick fix. The decision should be made after reviewing the dischargeability tests, lien position, the type of tax, and non-bankruptcy IRS remedies. Always consult both a qualified bankruptcy attorney and a CPA before filing to confirm how the rules apply to your situation.

Disclaimer: This article is educational and does not substitute for legal or tax advice. For advice tailored to your circumstances, consult a licensed bankruptcy attorney and a tax professional.