When it comes to dealing with tax debt, many taxpayers are torn between two very common options: discharge the tax debt by filing for Chapter 7 bankruptcy or settle the debt through an offer in compromise.
Here we explain what both alternatives consist of and how to know which one to choose according to your particular situation.
Chapter 7 bankruptcy is also known as “liquidation bankruptcy” because the court liquidates a portion of the debtor’s assets to distribute the money among creditors.
To qualify for Chapter 7 bankruptcy, taxpayers must meet the requirements set forth by the Bankruptcy Code. These requirements are often called the 3-year, 2-year, and 240-day rules.
- The 3-year rule. To discharge your back income taxes, they must be due at least three years before you file for bankruptcy.
- The 2-year rule. Under this rule, you must file your income tax returns at least two years before you file for bankruptcy.
- The 240-day rule. This rule states that taxes must have been assessed by the IRS at least 240 days before filing for bankruptcy. The original assessment date is usually the date you file your tax form or close to it. However, if you file an amended return or are audited and you owe additional taxes, then the 240 days of additional tax begins after the additional taxes are figured.
You should keep in mind that even if you meet the above requirements, the tax debt will not be dischargeable if:
- There is a tax lien, as a tax lien filed prior to bankruptcy will continue to attach to your property.
- The tax is a “trust fund” tax.
- The IRS has determined that there is tax evasion or fraud.
Although bankruptcy does not release the tax lien, if you meet the requirements of rules 3-2-240, you can ask the IRS to release the lien, which will happen if the taxes have been paid and there is little property for the lien. However, if after the discharge you still own significant property, the IRS will likely not remove the lien. In that case, you can negotiate the tax debt on the lien.
If paying your current tax debts will cause you significant financial hardship, the IRS will consider settling your debt through an Offer in Compromise. In this way, you will be able to settle your tax liabilities for less than the full amount owed.
To qualify for an OIC, you must meet the following requirements:
- You must have filed all tax returns.
- You must not be in an open bankruptcy proceeding
- You must have made all required estimated tax payments for the current tax year.
- If you are a business owner with employees, you must have made all required federal tax deposits for the current quarter.
In addition, for the IRS to accept an Offer in Compromise, it must be based on one of the following reasons:
- There is doubt as to liability; that is, there is a genuine dispute about the existence or amount of the correct tax liability under the law.
- There is doubt as to whether the IRS can collect the tax bill from you. There is doubt as to collectIbility in any case in which the assets and income of the taxpayer are less than the full amount of the tax obligation.
- The IRS may accept an OIC based on effective tax administration. This will happen when there is no doubt that the amount due is correct and collectible, but requiring payment of taxes could create an economic hardship or would be unfair and inequitable due to exceptional circumstances.
If the conditions are met, you can request an offer in compromise by completing IRS Form 656. The IRS will ask you to provide your financial information through the
Form 433-A/F (individuals) or 433-B (companies). In addition, you will need to provide additional documents so the IRS can verify your income and financial assets, such as bank records, pay stubs, etc.
To apply for an offer in compromise you must not be in an open bankruptcy proceeding. You can file for both an OIC and a Chapter 7 bankruptcy, but not at the same time.
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 must determine the impact that the potential bankruptcy filing may have on the collection of outstanding tax liabilities.
The IRS will determine how likely it is that you file for bankruptcy, considering whether you have filed for bankruptcy in the past, whether the IRS is the sole creditor, whether taxes would be dischargeable in bankruptcy, etc.
If the IRS determines that a Chapter 7 filing is possible, then it will settle your tax debt. The IRS will not accept less than the amount that would be recoverable from a Chapter 7 bankruptcy, except under special circumstances.
The process of an Offer in Compromise will suspend the 3-2-240 time period, adding time to the 3-2-240 requirements while the ICO is pending.
Once the discharge is entered, the IRS will determine the taxes to be discharged and make a determination of Doubt as to Collectibility under its OIC administrative procedures.
There are certain situations where an offer in compromise is the best option to settle tax debts you cannot afford to pay.
- In general, an Offer in Compromise may be a good choice if:
- The IRS is the only significant creditor you are dealing with.
- You are concerned about how a bankruptcy may affect your credit score.
- You want to get a federal tax lien.
Filing for bankruptcy is generally a good choice in the following circumstances:
- When taxes are discharged, and you have to file for bankruptcy due to other creditors.
- When taxes are cleared, and the IRS has denied your Offer in Compromise.
Remember to always consult with a qualified tax professional to determine which alternative is best for you to remedy your tax debt.