Bankruptcy is a legal process whereby individuals, businesses, and organizations can discharge or pay back debts with the help of a court appointed trustee. Realize there are different types or chapters and each will treat tax debt differently. Bankruptcy should be used as a last resort because not only does it have negative consequences (discussed below) but also it does not discharge recent taxes.
Bankruptcy can leave a stain on a taxpayer’s credit with the 3 credit bureaus for several years. In fact, it (depending on the type) can be left on your credit report. It is arguably much more severe than if you have collection accounts or unpaid creditor accounts. When your credit shows bankruptcy, lenders are hesitant to loan money whether its a mortgage, car loan, credit card. Moreover, even landlords who see this on a credit report may be reluctant to take this type of tenant because it shows you are not reliable in making payments.
The two common types of bankruptcy relevant to discharging or repaying tax debts is Chapter 7 and Chapter 13 which is discussed below. Chapter 11 is a better fit for businesses looking to reorganize debts, and Chapter 12 applies to individuals with farms. With all types of bankruptcy, there are certain conditions or requirements that need to be met in order to qualify.
In Chapter 7, nonexempt assets (set on state level) are liquidated and any remaining IRS tax debts are discharged unless qualifications are not met. If qualifications are not met, then the tax debt will need to be repaid after the bankruptcy process is over. Realize recent tax debt (not older than 3 years) cannot be discharged.
In Chapter 13, the more common of the applicable income tax bankruptcies, some IRS tax debt may be forgiven but typically these taxes have to be repaid with a payment plan. Normally assets do not need to be liquidated as a taxpayer’s income will finance the payment plan.