How to Reduce Taxes Owed via Bankruptcy

Filing a petition for bankruptcy results in an automatic stay in all new liens against property until the bankruptcy case is closed or dismissed. However, previously owed taxes are still part of the total debt load which must be resolved through bankruptcy proceedings.

Income taxes owed via Chapter 7 bankruptcy can be discharged if the taxes were assessed at least 240 days before filing for bankruptcy, if the taxes are due at least 3 years after your filing date after including all extensions, and if there has been no attempt to evade taxes previously. All previous tax returns must also have been filed at least 2 years prior to filing for bankruptcy, and all taxes for the previous year must have been paid. Payroll, trust fund, and other taxes are not eligible for discharge due to bankruptcy.

If your income is greater than your state’s median income or you can pay more than $100 a month over 5 years, you cannot apply for a Chapter 7 bankruptcy. Instead, you will have to apply for Chapter 13 bankruptcy. In this case, the Internal Revenue Service will try to institute a payment plan to pay back all back taxes owing. However, you may still be able to file for an offer in compromise (OIC).

If you have applied for a previous OIC, you cannot apply for a Chapter 7 bankruptcy for at least 30 days after the minimum 240 days. If you have previously filed for bankruptcy, add 6 months instead of 30 days.

Payment plans under Chapter 13 bankruptcy

Owed income taxes are not usually discharged after Chapter 13 bankruptcy. Instead, the Internal Revenue Service has implemented different types of payment plan to assist with paying back taxes. You can request an appropriate tax payment amount under the IRS Collection Financial Standards. The 2 types of payment plans are the streamlined installment plan and IRS collection.

You may qualify for a streamlined installment plan if you are employed, self-employed, or unemployed, if you owe less than $25,000 when you file your offer, and if you can pay off the tax bill within 5 years. Your payments will be based on the amount owed, the interest on the unpaid taxes, and any penalties incurred.

If you don’t meet the criteria for a streamlined agreement, you can set up monthly payments with the IRS under their Collection Financial Standards. File as for the streamlined installment plan, but do not submit the application fee with your form. It will be deducted from your first payment.

During the repayment period, interest and penalties continue to pile up on the unpaid portion of an installment agreement. You will also usually be required to pay user fees and all application fees.

Offer in compromise

As a last resort, you can offer the IRS an OIC. This is an agreement between a taxpayer and the IRS to settle for less than the full amount which is owed by the taxpayer. You may qualify for an OIC if you are employed, self-employed, or unemployed, if your total household income is $100,000 or less, and if you owe less than $50,000 when you file your offer.

Cancellation-of-debt income

In partial loan forgiveness, short sales, and foreclosures, the difference between the outstanding mortgage or agreed-upon mortgage balance and the owner’s equity in the house is considered cancellation-of-debt (COD) income. Until recently, all of this was taxable income at standard rates. If the mortgage is non-recourse debt which has been secured by collateral, the COD income is considered a capital gain. All COD income must be declared on Form 982.

Fortunately, home ownership tax exclusion rules now make an exception for homeowners who have lived in the principle residence for at least 2 of the past 5 years. Homeowners filing singly can claim a tax exclusion of up to $250,000 COD. For married homeowners filing jointly, the exclusion is $500,000. That should help most taxpayers who are underwater with their mortgage.

Homeowners who can demonstrate they are insolvent before discharging the mortgage will not be taxed on this basis. Homeowners who declare Chapter 7 bankruptcy are also not taxed on the forgiven portion of debts. Homeowners who declare Chapter 13 bankruptcy may be taxed, but may apply for a payment plan or order in compromise, as usual.


Always start by filing the tax return on time, even if you know you won’t be able to pay. That way, you won’t have to add a late filing penalty to the rest of your tax woes.

If you are falling behind on taxes, close to insolvency, or thinking about declaring bankruptcy, get professional assistance immediately. Do not negotiate any debt forgiveness or take other steps without working through the implications first with an expert in bankruptcy law. An improperly filed or poorly negotiated Chapter 13 bankruptcy can leave you even worse off than you were before declaring bankruptcy.