Bankruptcy law is federal, technical, and changes with each case's facts. This article is a general overview written by an accounting firm, not legal advice. Do not file, or decide against filing, based on it. Talk to a licensed bankruptcy attorney, and consider tax advice at the same time.
When a tax bill is larger than a business can ever pay, owners start asking whether bankruptcy is the way out. Sometimes it is part of the answer. More often it is a poor fit for the tax debt specifically, even if it helps with other debts. Here is how to think about it.
Taxes are treated differently from ordinary debt
In bankruptcy, many unsecured debts like credit cards and trade accounts can be discharged. Tax debts are treated more strictly. Certain income tax debts may be dischargeable if they meet specific conditions, and others are not. Which category your debt falls into depends on the tax type, the year, when the return was filed and assessed, and whether you filed honestly.
The general conditions for income tax discharge
In general terms, bankruptcy law looks at timing and compliance rules for income taxes, including how long ago the return was due, how long ago it was filed, and how long ago the tax was assessed. Late-filed returns, substitute returns prepared by the IRS, and tax involving fraud or willful evasion raise special problems. Because the exact periods and exceptions are technical, a bankruptcy attorney needs to apply them to your dates.
Taxes that are generally not discharged
- Trust fund payroll taxes: the income tax and employee Social Security and Medicare you withheld from wages are generally not dischargeable.
- The Trust Fund Recovery Penalty assessed against responsible individuals. See payroll tax problems.
- Recent taxes that fall inside the priority period.
- Taxes on returns that were never filed or filed fraudulently.
Liens can survive
Even when a personal liability is discharged, a federal tax lien that was filed before the bankruptcy can remain attached to property. That means the IRS can still collect from that property after the bankruptcy ends. See what happens when the IRS files a lien.
Your entity type matters
- Sole proprietors and single-member LLCs owe the tax personally, so an individual bankruptcy may address it, subject to the rules above.
- Corporations and LLCs taxed as corporations are separate legal entities. A business that liquidates generally cannot receive the same kind of discharge that an individual can, and its owners may still be personally liable for trust fund taxes.
- Partners and S corporation owners may have personal exposure that differs from the entity's.
Types of bankruptcy, in outline
- Chapter 7: liquidation, typically used by individuals and by businesses closing down.
- Chapter 13: a repayment plan for individuals with regular income, which can allow priority taxes to be paid over time.
- Chapter 11: reorganization for businesses and individuals with complex finances, usually more expensive.
- Chapter 7, 11, or 13 outcomes for taxes differ, and an attorney should explain which, if any, helps.
Alternatives to compare first
Bankruptcy has long-term consequences for credit, assets, and the business. Compare it with the non-bankruptcy tools before deciding: small business tax debt relief, payment plans, offer in compromise, and currently-not-collectible status. For many owners, one of those solves the problem without bankruptcy. The automatic stay in bankruptcy can pause collection, but it does not erase the underlying obligations.
What an accountant contributes
- Pulling IRS transcripts to establish assessment dates and balances.
- Identifying which tax types and years are in play.
- Getting any unfiled returns filed properly, since that affects discharge.
- Helping the attorney understand your business finances.
Our IRS resolution service can organize your tax records before you meet an attorney. To get help with your business tax situation, send your notices and a list of tax years. This article is not legal advice, and results depend on individual facts.
