A Primer on Bankruptcy Options and Potential Tax Liabilities

bankruptSo, you are struggling financially and are curious about the bankruptcy option. You have heard the rumors about those who have filed and prospered; you’ve heard the tales about those who have filed and failed. Whatever the case may be, you want to learn more.

Bankruptcy is a declared inability to pay off debts. The process is extremely serious and meant to be a last resort, but it often becomes a reality for individuals with monetary issues.

All too often, though, individuals immediately jump to bankruptcy as the most obvious fix when in fact an alternative option may have been the better long term choice. For example, if you owe back taxes and declare bankruptcy, long term damage may be placed on your credit and sometimes you may end up owing the taxes even after the bankruptcy.

The IRS could also come after you, especially if you have declared bankruptcy but in reality could have paid off debts using a payment plan or by liquidating certain personal assets. And the last thing you want is the IRS coming after you!

Needless to say, bankruptcy may or may not be the right solution for you. So before taking any action, it is important to work with a tax attorney or bankruptcy attorney to become up to date with all rules and types of bankruptcy if your main intention is to resolve tax debts.

There are four types of bankruptcy pertinent here. These types are classified under chapters 7, 11, 12, and 13. Within each case, several rules are applied and may vary with regards to tax liabilities.

The more relevant bankruptcy types here that apply to personal tax debt would be Chapter 7 and 13. Chapter 11 typically applies to businesses and Chapter 12 to farms.

Here is a brief summary of each, along with their potential tax liabilities:

Chapter 7 Bankruptcy

Chapter 7 is the most simple and straightforward declaration of bankruptcy. It follows basic liquidation and becomes the most expedited process for bankruptcy. The people I mentioned earlier- the ones who jump to bankruptcy as a quick fix — beware. Taxes may be forgiven through a Chapter 7 filing; however, there are several requirements. If your taxes were assessed 240+ days before the filing, tax evasion has not been suspected, taxes are 3 or more years old before the filing, tax returns have been filed for the past 2 years, and there is strictly income tax debt, you may be able to release tax debt through this type bankruptcy. If these qualifications are not met, then you will be responsible for taxes after the bankruptcy. One thing that is good with Chapter 7 (and other types) is that IRS collections are usually halted during the bankruptcy proceeding.

Chapter 11 Bankruptcy

Chapter 11 is used mainly by businesses. This type of bankruptcy can allow for businesses to restructure or reorganize in hopes of turning a profit in the future. There are several regulations and monetary restrictions associated with Chapter 11, including time requirements and expensive fees. Back taxes are also usually untouched, and will continue to linger during the restructuring period. Although IRS collection efforts are halted during the proceedings, interest is normally not, which continues to accrue.

Chapter 12 Bankruptcy

Chapter 12 bankruptcy relies on a similar set of rules as Chapter 13, but stands with regards to family farms and fishermen (an individual or corp). In 2005, the bankruptcy code was slightly changed where now a farmer who downsizes to pay off debts and realizes capital gains does not have to pay them in full in order to achieve a bankruptcy discharged (the taxes would be an unsecured claim).

Chapter 13 Bankruptcy

Commonly referred to as Wage Earner Bankruptcy, Chapter 13 deals with individuals who have a regular source of income. Moreover, under Chapter 13, taxes are normally not discharged but paid back over time (sometimes at a discount). Chapter 13 is an effective means to obtain a payment plan with the IRS. This type of bankruptcy is extremely popular but also contains many requirements. For one, you must prove that you have no more than roughly $337,000 in unsecured debt and no more than roughly $1.01 million in secured debt. You must also prove that you have the ability to pay $100 upfront, have filed your tax returns for the past four years, and have completed a credit counseling session. Lastly, taxes will most often stop increasing because normally interest and penalties with unsecured taxes cease (not secured taxes) with Chapter 13.

It is important to identify your individual case and define which bankruptcy type it falls under prior to taking any action. You should also consult a tax attorney or bankruptcy attorney as they will be able to provide you with the best tax and bankruptcy guidance. From there it becomes easier to analyze your situation and realize the possible impacts of your decision, particularly with regards to tax debt forgiveness.

Photo Credit: ralph and jenny


  1. 1


    “You have heard the rumors about those who have filed and prospered; …”

    I used to work with a girl who would live way above her means and then file for bankruptcy every seven years. I don’t believe she will ever prosper, because she refuses to live within her means or learn a lesson. Bad credit and a bunch of shoes isn’t my vision of prospering. Not to mention, she wound up paying a fortune for everything, because of her credit history and lack of cash.

    One critical piece of information reagrding bankruptcy, student loans usually aren’t eliminated during the process. So, you may be stuck with them for a long time. Be carefull with student loans.

  2. 2

    Spedie says

    My ex did a Chapter 13 long after we were divorced. When we divorced I took all debt and paid it off using the Dave Ramsey plan. When we divorced we also split our savings account, which was $30K. We had an amicable divorce with below normal divorce fees. I did not wring every penny out of the guy.

    He didn’t fare too well after the bankruptcy. I can’t imagine the stress on him with his new wife and in other areas of his personal life. It looks bad.

    My best advice: do not file bankruptcy, get on a budget, live way below your means, stay away from consumer credit counseling agenies, and pay your debt off.

    Oh, and do not hire a bankruptcy attorney with the last name of Swindler – this is what my ex did!

    Yes, that is a true story, every detail, even the Swindler part.

  3. 3


    Bankruptcy can be a positive move for a lot of people; after all, it isn’t the bankruptcy filing that’s the issue, but the events that produced the need for it.

    That said, it really addresses a short term problem – the imbalance between debt on one side and income and assets on the other. Fixing this can be blessed relief.

    The problem is that it does nothing to cure longer term problems like poor money management. Money habits have to change in order for bankruptcy to be truly effective.

    If bankruptcy can do anything to fix a person’s finances, it should be to convert them from debtors into savers, that way they become self-financing.

  4. 4


    Years ago I knew someone who filed for bankruptcy right after college. He had accrued $10,000 in credit card debt and didn’t understand his options for paying it back. It was a fool-hardy decision that lingered over his head for many years. The debt amount was so small in comparision to what many people deal with on a day-to-day basis. Hopefully he learned his lesson.

    • 5


      Wow $10,000? It probably was a mountain to him at the time, but it’s sad to file for such a relatively small amount, especially if he had a college degree.

      One of the problems with filing for such a small amount is that he can’t file again for eight years (I think!), so if he has a medical catastrophe within that time he won’t be able to get relief through the courts for a far larger amount of debt. Outsized medical bills are one of the biggest reasons for BK.

    • 6


      @Hope and @Kevin: I agree with both of you guys. Bankruptcy is only a big ol’ band-aid for a disease, living beyond one’s means, that really requires major surgery.
      @Spedie: An attorney called Swindler? That’s better than Dewey, Cheetham and Howe! LOL

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