A common misconception is that you cannot discharge federal tax debt in Chapter 7 bankruptcy. In fact you can both discharge some of your tax debts under Chapter 7 Bankruptcy, as well as settle your debts with an Offer in Compromise. However, it’s not as easy as the “tax resolution” companies often advertise with their promises of “0% down” and settling your debt for “pennies on the dollar.”
- 1 Chapter 7 Bankruptcy
- 2 Offer in Compromise
- 3 Offer-in-Compromise vs. Chapter 7 Bankruptcy
Chapter 7 Bankruptcy
Tax debt is dischargeable in Chapter 7 bankruptcy if they meet specific requirements under the Bankruptcy Code. These requirements are often called the 3-year, 2-year, and 240-day rules.
- The 3-year rule. The return was due at least three years ago before you file for bankruptcy. For example, Bob’s 2010 return was due on April 15, 2011. The earliest he can file for bankruptcy for his 2010 tax debt is April 15, 2014. Note that a tax return extension will also extend the 3-year rule.
- The 2-year rule. The return must be filed at least two years before the bankruptcy filing. For example, Bob’s 2010 return was due on April 15, 2011, but didn’t actually file his tax return until October 31, 2011. The earliest he can file for bankruptcy for his 2010 tax debt is October 31, 2013.
- The taxes were assessed at least 240 days ago. For most taxpayers, the taxes are considered assessed as of the date the return was filed. However, if you file an amended return or are audited and owe additional taxes, then the 240 days on the additional tax begins to run when the additional taxes are assessed.
Even if you meet the above, the tax debt is not dischargeable if:
- There is a tax lien. A tax lien filed prior to bankruptcy will continue to attach to your property.
- The tax is a “trust fund” tax such as FICA, Medicare, and other mandatory withholdings (applies to businesses with employees).
- The IRS has determined there is tax evasion or fraud.
A note on tax liens. As mentioned above, bankruptcy does not release a tax lien. However, if you meet the 3-2-240 requirements, you can request for IRS to release the lien, which they may do if the taxes have been discharged and there is little property for the lien to attach. If you still own significant property after the discharge, then the IRS will likely not remove the lien. However, it is possible to negotiate the tax debt on the lien.
Offer in Compromise
If paying your existing tax debts will cause significant financial difficulty, the IRS will settle your tax debt through an Offer in Compromise (OICs). The IRS wants to get the most it can in a reasonable amount of time, and if that means negotiating the debt they will.
Pre-Qualifiers for Filing an OIC
- You must not be in an open bankruptcy proceeding
- You must have filed all required federal tax returns
- You must make all estimated tax payments
- If you are self-employed, you must have submitted all required federal tax deposits
Requirements for Filing an OIC
- There is some doubt as to whether the IRS can collect the tax bill from you – now or in the foreseeable future. The IRS calls this “doubt as to collectibility.”
- due to exceptional circumstances, payment of your full tax bill would cause an “economic hardship” or would be “unfair” or “inequitable.”
- There is some doubt as to whether you actually owe all or some of the debt. The IRS calls this “doubt as to liability.”
After you and your attorney have identified which condition(s) exists, you can start your application by completing IRS Form 656. There is a $186 application fee. In addition to the form, you will need to provide the following:
- Financial information by filling out Form 433-A/F (individuals) or 433-B (businesses). It is extremely important to be truthful and accurate on this form.
- Various documents to verify your income and financial assets – bank records, vehicle registration, pay stubs, etc.
How much should you offer?
You will calculate your minimum offer amount by following the instructions on Form 433. Without going into details, the formula will take into consideration the net realizable value of your assets (i.e, how much your assets would be worth if they were sold) and your excess monthly income after subtracting your monthly expenses from your monthly income.
Special consideration is given to those with physical and psychological impairments, bleak financial prospects due to advanced age (over 60), drug or alcohol related problems, or a family members problem if it affects your finances. To bring these issues to the attention of the revenue officer, you will attach a letter with supporting documents (e.g., medical records).
What if your offer is rejected?
IRS will reject offers for usually one of two reasons:
- The offer is too low
- You have been convicted of a serious crime in the past
If the offer is too low, the IRS will state the acceptable amount. You can also request a copy of the Revenue Officer’s report through a Freedom of Information Act (FOIA) request.
If you wish to increase your offer, you can do so within a month by simply writing a letter without having to resubmit your application.
The second option is to appeal your rejected offer. You can further negotiate with the assigned Revenue Officer and if that fails, you can submit IRS Form 13711 to start a formal appeal.
Offer-in-Compromise vs. Chapter 7 Bankruptcy
As you recall above, one of the conditions for applying for an OIC is that you are not in an open bankruptcy proceeding. You can both apply for an OIC and file for Chapter 7, but not at the same time.
Applying for OIC before Chapter 7 filing
Under Internal Revenue Manual 188.8.131.52.2, when a taxpayer or representative states during an offer investigation that a bankruptcy petition will be filed if the taxpayer’s offer is not accepted, the offer examiner/offer specialist must determine whether the potential for a bankruptcy filing actually exists and the impact the possible bankruptcy filing may have on the collection of the outstanding tax liabilities.
The IRS will consider how likely it is for you to file for bankruptcy – have you filed in the past, is IRS the sole creditor, would the taxes be dischargeable in bankruptcy, etc. If the Service determines there is potential for a Chapter 7 filing, then the Service will negotiate your tax debt. Under no circumstance, however, will the IRS accept a settlement that would be less than what it would recover under a Chapter 7 bankruptcy.
Warning! The OIC process will suspend the 3-2-240 time period, thereby adding time to the 3-2-240 requirements while the OIC is pending. Additionally, indicating to the IRS that you are considering filing bankruptcy requires the OIC offer examiner to determine whether the IRS should file a notice of federal tax lien to protect the government’s assets. As you recall above, a lien is not automatically released after a bankruptcy discharge.
Applying for OIC after Chapter 7 discharge
Once the discharge is entered, the Service will be able to determine which taxes are discharged and will be able to make a determination of Doubt as to Collectibility under its administrative OIC procedures.
Which one should I choose?
There are many factors in determining which option would be best for your situation, such as:
- Has the IRS filed a lien?
- How quickly do you need debt relief?
- Is the IRS debt itself causing financial problems, or do you also have other debt?
- Which option will have the lowest settlement payment?
- Which one will be most likely successful?
Since 2012 the IRS has been more willing to compromise with taxpayers on debts. Up to 40% of OICs have been accepted in recent years. You should seek the assistance of an experienced tax attorney to ensure the greatest chance of your OIC being accepted. We can help you determine whether a Chapter 7 or 13 filing or an offer in compromise would be more beneficial for you.