In general, taxes cannot be cancelled in Chapter 7. There are exceptions to this if the taxes are more than three years old and meet other tests. This blog post does not address this question, but is simply an explanation of how non-dischargeable taxes may end up being paid in a chapter 7.
There are two kinds of Chapter 7s: asset and no asset cases. MOST chapter 7s are no asset cases, meaning all of the person’s property is exempt or protected, and they pay nothing to the bankruptcy trustee to settle their debts.
In some cases, however, there is property that is collected and sold and the money distributed to creditors. For example, if a person had a piece of raw land worth $5000 that they did not live on, this could be sold and distributed to creditors. If the person had $80,000 in debts, this would seem like a fair deal—give up $5,000 to discharge $80,000.
Let’s say, though, that of the $80,000, the person owed $2500 in last year’s income taxes—a non-dischargeable debt they would be responsible for after bankruptcy. Since money collected by a trustee is distributed in a certain order, with priority debts (such as taxes) being paid first, the proceeds of the sale of the property could be directed to pay the taxes, if a proof of claim is filed by the IRS in the case. Sometimes, however, the IRS does not file a proof of claim, and the money would then be distributed to unsecured creditors and the taxes would not be paid.
There is a provision, however, that allows debtor’s counsel to file a claim on behalf of the IRS, to attempt to get the taxes paid by the trustee even if the IRS does not file a claim. In this case, the person loses the land, but the taxes get paid, creating a good result for all concerned.
