Tax Debt and Bankruptcy in Pennsylvania

Most people are told that taxes can never be discharged in bankruptcy. That is not true. Older personal income tax — owed to the IRS or to the Pennsylvania Department of Revenue — is frequently dischargeable in Chapter 7, and the tax that isn't can be paid through a Chapter 13 plan without further penalties or interest.

The three timing rules for dischargeable income tax. Personal income tax is dischargeable in Chapter 7 only if all of these are satisfied, under 11 U.S.C. §§ 507(a)(8) and 523(a)(1):

1. The three-year rule. The return was due — including extensions — more than three years before your filing date.

1. The two-year rule. You actually filed the return, and you filed it more than two years before your bankruptcy filing date. A substitute return prepared by the IRS on your behalf does not count as your return in most courts.

1. The 240-day rule. The tax was assessed more than 240 days before you file. An offer in compromise or a prior bankruptcy tolls this clock and extends it.

On top of that, the return cannot be fraudulent and you cannot have willfully attempted to evade the tax. Miss one of these and the tax is not dischargeable — which is why timing a filing by a few weeks sometimes saves thousands of dollars. I pull IRS account transcripts before filing so we are working from assessment dates, not guesses.

What is never dischargeable. Trust-fund payroll taxes you were responsible for withholding (26 U.S.C. § 6672), sales tax you collected, tax on an unfiled return, recent income tax inside the three-year window, and fraud penalties all survive. These are priority claims under § 507(a)(8).

Recorded tax liens survive even a discharge. This trips people up. A discharge wipes out your personal liability for the tax, but a federal tax lien or a PA Department of Revenue lien recorded before you filed still attaches to the equity in property you owned at that time. We check for recorded liens early, because that fact often decides between Chapter 7 and Chapter 13.

How Chapter 13 handles the tax you can't discharge. This is where Chapter 13 shines for tax problems. Priority tax debt is paid in full through your plan over three to five years, but with two enormous advantages: penalties stop accruing, and post-petition interest is generally not paid on priority tax claims in a case where unsecured creditors are not paid in full. Meanwhile the older, dischargeable tax gets lumped in with your general unsecured debt and is wiped out at the end of the plan along with your credit cards. For someone carrying five years of mixed IRS and PA Department of Revenue balances, a Chapter 13 is often dramatically better than an installment agreement.

Pennsylvania Department of Revenue debt follows the same framework. PA personal income tax is treated under the same Bankruptcy Code timing rules as federal income tax. The automatic stay stops PA collection activity, including bank attachments and referral to a private collection agency, the moment we file. Local earned income tax collected by agencies like Keystone Collections or Berkheimer is analyzed the same way.

File your returns. If you have unfiled returns, get them filed. Unfiled tax years are non-dischargeable no matter how old they are, and the Chapter 13 trustee will require that all required returns be filed before your plan is confirmed. Filing them starts the two-year clock running.