Tax Penalties and Interest in a Bankruptcy

by Beverly Bird
Complex rules determine whether you can discharge tax debts.

Complex rules determine whether you can discharge tax debts.

Ryan McVay/Photodisc/Getty Images

If you've ever found yourself in a position where your income tax debt was more than your available resources to pay your tax debt, you know what happens next. The longer the tax bill remains outstanding, the greater the debt becomes. The Internal Revenue Service incrementally adds on interest and penalties. The good news is that, contrary to popular belief, income taxes are sometimes dischargeable in bankruptcy. The associated penalties and interest are often erased, as well.

The Initial Tax Debt

Interest can be discharged in bankruptcy only if the associated taxes are also dischargeable. Only income taxes are eligible for discharge, and they must have come due at least three years prior to the bankruptcy. Another catch is when you actually filed the return. For example, if you completed your tax form only to discover that you owe the IRS $10,000, you might not have filed it right away because you were scrambling for ways to pay the debt. At least two years must pass from the date you submitted the return. You'll meet this rule if you filed by the return's due date three years ago. Otherwise, you must wait 24 months from the date you actually filed. Another pivotal date is when the IRS actually assessed the tax bill against you – this is when the IRS noted in its records what you owe. It's a bit of a gray area, but you can safely begin calculating, beginning with the date the IRS began sending you notices, demanding payment. You must wait an additional 240 days or eight months after this, before the debt is eligible for discharge. If your tax debt meets all these criteria, the associated interest is dischargeable, as well.

Penalties Are Unsecured Debts

The bankruptcy code treats tax penalties differently from interest, and you get a bit of a break here. Penalties must only meet the three-year rule. In other words, you might still owe the underlying tax bill and the interest because they don't meet all the rules for discharge, but you can get rid of the penalties if they result from a tax return that was due at least three years before the bankruptcy. Tax penalties are treated as unsecured debts in bankruptcy, just like credit cards. This means they're paid last, if at all. If you filed for Chapter 7, your debts are paid through liquidation of your non-exempt assets. If you filed for Chapter 13, they're paid from your disposable income. If you don't have enough assets or income to cover payment to all your creditors, unsecured debts are discharged even, if these creditors don't receive all you owe them, or even any payment at all.

The Automatic Stay

The IRS has a reputation for being omnipotent, but it's not immune to bankruptcy's automatic stay. When you file for bankruptcy, your creditors are legally barred from trying to collect from you after this point, and this applies to the Internal Revenue Service as well. The bankruptcy code does give the IRS a little wiggle room, however. It can continue assessing interest and penalties up until the time you receive a Chapter 7 discharge or you complete your Chapter 13 plan and receive a discharge, but it can't take any steps to try to collect the money from you during this time. If and when you receive your discharge, the IRS abates these extra fees – you don't have to pay them if they meet all requirements for discharge.

An Exception to the Usual Rules

If the IRS places a lien against your property for the unpaid taxes, this changes everything. The IRS can't do this after you file for bankruptcy, but if it does so before you file, the associated penalties are no longer treated as unsecured debts. The lien secures them. If you ever sell your property, the debt would be satisfied from the proceeds.