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Tax Implications of Filing for Bankruptcy in Texas

By Javier Aponte | November 26, 2024

Filing for bankruptcy is a significant step toward financial freedom, but what happens when Uncle Sam is part of the equation? If you’re considering bankruptcy and have tax debts, you’re probably wondering how filing will impact your obligations to the IRS. Will your taxes be discharged? What about future filings?

The good news is that bankruptcy can provide relief for certain tax debts under specific conditions. But as with most things involving taxes, the details matter. Let’s unpack the tax implications of filing for bankruptcy in Texas, so you can make an informed decision and avoid any surprises.

Understanding Bankruptcy and Taxes

Question: Can bankruptcy help with tax debt?

Clarification: Yes, but not all tax debts are treated equally in bankruptcy. Whether taxes are dischargeable depends on factors like the type of tax, the age of the debt, and your filing history.

Two Key Concepts to Know:

  1. Tax Discharge in Bankruptcy: Some old tax debts can be eliminated entirely through bankruptcy.
  2. Non-Dischargeable Taxes: Other tax debts, such as recent or fraudulent filings, stick with you no matter what.

Let’s dive deeper.

How Bankruptcy Handles Tax Debt in Texas

Texas is known for its debtor-friendly laws, but when it comes to tax debt, federal rules largely apply. Here’s how the two most common types of bankruptcy—Chapter 7 and Chapter 13—deal with taxes:

Chapter 7 Bankruptcy and Tax Debt

What It Is: Chapter 7 is a liquidation bankruptcy that discharges qualifying debts, often within 4–6 months.

How It Handles Taxes:

  • Certain income tax debts can be discharged if they meet specific criteria (see below).
  • Payroll taxes, fraud penalties, and recent tax debts are generally non-dischargeable.

Pro Tip: Chapter 7 is ideal if your tax debt is older and qualifies for discharge.

Chapter 13 Bankruptcy and Tax Debt

What It Is: Chapter 13 allows you to reorganize debts into a repayment plan over 3–5 years.

How It Handles Taxes:

  • Priority tax debts (like recent income taxes) must be paid in full during the repayment period.
  • Non-priority tax debts (e.g., older taxes) may be partially or fully discharged at the end of the plan.

Pro Tip: Chapter 13 can stop IRS collection actions and give you more time to pay taxes under manageable terms.

When Are Taxes Dischargeable in Bankruptcy?

Question: What conditions must be met to discharge tax debt?

Clarification: To discharge federal income taxes through bankruptcy, they must meet the five-year test and other criteria:

  1. Income Tax Debt Only: Only personal income taxes are eligible. Payroll taxes, fraud penalties, and trust fund recovery penalties are non-dischargeable.
  2. Three-Year Rule: The tax return must have been due at least three years before filing for bankruptcy.
  3. Two-Year Rule: The return must have been filed at least two years before filing for bankruptcy.
  4. 240-Day Rule: The IRS must have assessed the tax debt at least 240 days before the bankruptcy filing.
  5. No Fraud or Willful Evasion: The tax return must not be fraudulent, and you must not have willfully tried to evade payment.

Example: If you owe taxes from 2018, filed the return on time, and meet the above conditions, those taxes may be dischargeable in bankruptcy.

For more details on IRS tax rules in bankruptcy, visit the IRS Bankruptcy Tax Guide.

The Role of the IRS During Bankruptcy

Question: What happens to IRS collection actions when you file for bankruptcy?

Clarification: Filing for bankruptcy triggers an automatic stay, which halts most collection actions, including those from the IRS.

What the Automatic Stay Covers:

  • Wage garnishments.
  • Bank levies.
  • Tax liens (though existing liens remain in place).

Pro Tip: While the automatic stay offers temporary relief, it doesn’t erase IRS liens already placed on your property.

Tax Refunds and Bankruptcy

Question: Will I lose my tax refund if I file for bankruptcy?

Clarification: It depends. In Chapter 7 bankruptcy, tax refunds for the year you file are considered part of your bankruptcy estate and may be used to pay creditors.

In Chapter 13: Refunds may be included in your repayment plan, but exemptions can help you keep some or all of your refund.

Pro Tip: Work with an attorney to maximize exemptions and protect your refund where possible.

Common Misconceptions About Bankruptcy and Taxes

Myth #1: All Tax Debts Are Wiped Out in Bankruptcy

Reality: Only certain tax debts qualify for discharge under strict conditions.

Myth #2: Filing for Bankruptcy Will Stop Me from Ever Filing Taxes Again

Reality: Bankruptcy doesn’t excuse future tax filing requirements. You must continue filing returns and paying taxes post-bankruptcy.

Myth #3: Bankruptcy Erases IRS Tax Liens

Reality: Bankruptcy can discharge the underlying tax debt, but liens may remain on your property unless resolved separately.

The Benefits of Filing Bankruptcy for Tax Relief in Texas

While bankruptcy may not eliminate all tax debt, it offers significant benefits:

  • Halts Collection Actions: The automatic stay provides immediate relief from IRS harassment.
  • Manages Payment Plans: Chapter 13 lets you pay taxes over time without penalties.
  • Protects Assets: Texas exemptions safeguard your home, car, and retirement accounts.

Learn more about Texas bankruptcy exemptions from the National Consumer Law Center.

Why Work with a Trusted Bankruptcy Attorney in Texas?

Question: How can an attorney help with tax-related bankruptcy issues?

Clarification: Navigating the intersection of bankruptcy and taxes is complex. A trusted bankruptcy attorney ensures:

  • Accurate filing to meet discharge criteria.
  • Proper use of exemptions to protect assets like tax refunds.
  • Effective negotiation with the IRS for manageable outcomes.

Pro Tip: Don’t leave your financial future to chance—partner with a professional who knows the ins and outs of Texas bankruptcy law.

Breaking the Stigma: Bankruptcy Is a Smart Financial Tool

Bankruptcy isn’t about failure—it’s about reclaiming control. If you’re struggling with tax debt, filing for bankruptcy in Texas can be the fresh start you need. By understanding the tax implications and working with a knowledgeable attorney, you can build a brighter financial future.

Take Control of Your Taxes and Debt Today

If tax debt is weighing you down, don’t wait. Visit Kisch Consumer Law to schedule a consultation. Our team specializes in helping Texans navigate bankruptcy and achieve real IRS debt relief.

Your financial freedom is just a click away—let’s make it happen together!

Posted in Blog, Kisch Consumer Law