Optima Tax Relief’s Chief Tax Officer and Lead Tax Attorney, Phil, answers another tax question from Reddit. This time, the topic is bankruptcy and how tax debt is treated during the process. The taxpayer in this scenario has a $25,000 tax debt with the IRS and is currently on an installment agreement. However, when reviewing their bankruptcy case through the PACER system, they notice something confusing: the balance shows $25,000 total, but only $13,000 is listed as priority debt. What does that actually mean?
What Priority Tax Debt Means
What this taxpayer is seeing is a breakdown of how their tax debt is treated in bankruptcy. The $13,000 labeled as priority debt is the portion included in the bankruptcy plan. Depending on the type of bankruptcy filed, such as Chapter 7 or Chapter 13, this portion may survive the bankruptcy or repaid through the plan. Priority tax debts generally will not be discharged and will survive the bankruptcy process.
Why Not All Tax Debt Qualifies
One of the biggest misconceptions about bankruptcy is that all tax debt disappears. In reality, strict rules determine whether tax debt can be discharged. Phil highlights the key guideline often referred to as the “3-2-240 rule.”
- The tax return must have been due at least 3 years before the bankruptcy filing date, including any extensions.
- The return must have been filed at least 2 years ago.
- The tax must have been assessed at least 240 days ago.
If these requirements are not met, the tax debt typically cannot be discharged in bankruptcy. That’s why more recent tax balances often remain after the bankruptcy process ends.
What Happens to the Remaining Balance
In this example, the remaining $12,000 is likely considered non-priority unsecured debt that may not be included in the bankruptcy plan. Once the bankruptcy case concludes, the taxpayer may still need to resolve that balance with the IRS.
Important Considerations Before Filing
Filing bankruptcy triggers an automatic stay, which stops creditors, including the IRS, from collecting. While this can provide temporary relief, it can also limit your ability to actively negotiate with the IRS during the bankruptcy process. For that reason, understanding your options and planning carefully before filing is critical.
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