Does Bankruptcy Cover Taxes?

Basics

While all tax debt can be restructured through Chapter 13 bankruptcy, only those tax debts less than 3 years old can be included in a Chapter 7 bankruptcy. For the purposes of Chapter 13, recent taxes are considered priority claims and thus must be repaid in full over the duration of the repayment plan, which is typically 2 to 5 years.

Chapter 7 and Taxes

Chapter 7 allows for permanent legal forgiveness of most debts, including taxes that are more than 3 years old. However, taxes less than 3 years old must be paid in full. This usually includes local, state and federal taxes and any associated penalties. Taxes older than this can usually be discharged in a Chapter 7 case, unless fraud is suspected. Failure to file tax returns could mean the resulting debts cannot be included in Chapter 7 bankruptcy.

Chapter 13 and Taxes

Chapter 13 is a structured debt repayment plan supervised by a federal bankruptcy court, which usually takes 2 to 5 years to fully complete. During the plan, new credit cannot be obtained without court approval. Recent taxes, along with child support, alimony, student loans and court fines are considered priority claims and must be repaid in full. Older taxes can be repaid in part as agreed by the court, and these are treated like credit card debt and loans. However, older taxes will probably still take priority over credit card debt, meaning that more of your credit card debt may be forgiven to make room for repayment of as many back taxes as possible.

Bankruptcy and Tax Refunds

Bankruptcy does have the potential to affect tax refunds. The debtor never has to disclose on his or her tax return that there was a bankruptcy case. However, the petitioner can be compelled to turn over his first tax refund in a Chapter 7 case to offset any creditor losses. In addition, some Chapter 13 plans require the person to hand over as much as 50 to 100 percent of his annual tax refunds to go toward their debt repayment plan. Reducing the amount of tax refund to meet this requirement while still not losing a lot of money can be done by legal methods, such as reducing the amount of tax withheld from a paycheck, thus reducing a due refund, or investing in a company's 401K plan.