How Does Bankruptcy Affect Your Taxes in Michigan?

Owing the IRS money feels like being followed by a slow, patient shadow. It does not yell, it does not knock, it just waits, adds interest, and keeps coming back. Add a stack of other bills on top of that tax debt, and it is easy to feel stuck.

The good news is that Michigan residents who file for bankruptcy sometimes find that a portion of their tax debt can be wiped out, while other tax debt may be addressed through a court-supervised repayment plan. The bad news is that tax debt is one of the more complicated corners of bankruptcy law, and getting it wrong can mean losing a chance at real relief.

At Hammerschmidt Stickradt & Associates, we work with people across Walled Lake, Wyandotte, and the rest of Michigan who are trying to figure out whether Chapter 7 or Chapter 13 can help with money owed to the IRS or the Michigan Department of Treasury. This article breaks down how bankruptcy and taxes in Michigan actually interact, what the law says, and what you should expect if tax debt is part of your financial picture.

What Happens to Your Tax Debt When You File for Bankruptcy in Michigan?

When someone files a bankruptcy petition in the U.S. Bankruptcy Court for the Eastern District of Michigan or the Western District of Michigan, an automatic stay goes into effect immediately under 11 U.S.C. § 362. This stay stops most collection actions, including many IRS and Michigan Treasury collection efforts, such as wage garnishments and bank levies, at least temporarily.

But not all tax debt is treated the same way. Bankruptcy law separates tax debt into categories, and which category your debt falls into determines whether it can be discharged, reduced, or must be paid in full through a repayment plan. Income taxes are treated differently than payroll taxes withheld from employees, and older tax debt is treated differently than a tax bill from last year.

Does Bankruptcy Discharge Create Taxable Income?

Generally, no. Debt discharged through bankruptcy is generally not treated as taxable cancellation-of-debt income. This is different from debt forgiven outside bankruptcy, which can sometimes create taxable income under federal tax law.

Bankruptcy does not eliminate every tax obligation, however. You may still need to file required tax returns and report income as required by law.

Can Bankruptcy Discharge Tax Debt in Michigan?

This is the question most people ask first, and the honest answer is “sometimes.” Federal income tax debt, including IRS income tax debt, can be discharged in a Michigan bankruptcy case, but only if it meets the requirements under 11 U.S.C. § 523(a)(1) and 11 U.S.C. § 507(a)(8). Attorneys sometimes call this the “3-2-240 rule,” but the calculation can be more complicated than those three numbers suggest.

For a federal income tax liability to potentially qualify for discharge, the applicable requirements generally include:

• The tax return was due at least three years before the bankruptcy filing, including any applicable extension.
• The return was filed at least two years before the bankruptcy filing.
• The tax was assessed at least 240 days before the bankruptcy filing.
• The taxpayer did not file a fraudulent return or willfully attempt to evade or defeat the tax.
• The tax liability is not one of the types of taxes that bankruptcy law treats as nondischargeable, such as certain taxes the debtor was required to collect or withhold for the government.

Certain events can extend or toll these time periods, including some prior bankruptcy cases and offers in compromise. That is why the relevant tax returns, assessment dates, and IRS or Michigan Treasury records should be reviewed before deciding whether a particular tax debt is dischargeable.

If a federal or state income tax liability satisfies the applicable discharge requirements, a Chapter 7 filing may eliminate the debtor’s personal liability for that qualifying tax debt. The treatment of related interest, penalties, and tax liens can be different, however, so the entire tax account should be reviewed rather than assuming that every amount associated with a tax year will be discharged. If the tax debt does not qualify for discharge, a Chapter 13 plan may still provide a way to manage the debt through a court-supervised repayment plan.

Does the IRS File a Proof of Claim in Bankruptcy?

The IRS may file a proof of claim after receiving notice of a bankruptcy case if it has a federal tax claim. A proof of claim is a formal document that identifies the amount and type of debt the IRS contends is owed. It can be particularly important in a Chapter 13 case because the claim can affect how tax debt is treated and how much must be paid through the repayment plan.

The IRS does not automatically file a proof of claim in every bankruptcy case simply because a filer has tax debt. Governmental units generally have 180 days after the order for relief to file a timely proof of claim, subject to special rules that apply to certain tax returns in Chapter 13 cases. In some Chapter 13 cases, the IRS may also file an estimated proof of claim when required tax returns have not been filed.

This matters because the IRS’s proof of claim can become an important part of determining how much tax debt must be addressed through a Chapter 13 plan. If you believe the IRS’s claim is wrong, such as listing an incorrect amount or classifying a tax debt incorrectly, you or your attorney may be able to object to the claim in bankruptcy court. Michigan Treasury has a similar process for asserting state tax claims in bankruptcy.

How Does Chapter 7 Tax Debt Discharge Work in Michigan?

Chapter 7 is often called a liquidation bankruptcy, and it moves fairly quickly compared to Chapter 13. For tax debt specifically, Chapter 7 may eliminate personal liability for qualifying tax debt when the applicable discharge requirements are met. But dischargeability depends on the nature of the particular tax liability and the requirements of federal bankruptcy law. Tax, interest, penalties, and liens may not all receive identical treatment, so a tax account should be reviewed by tax period and by the type of liability involved.

One detail that surprises a lot of people is that filing a Chapter 7 case does not necessarily erase a federal tax lien that was properly recorded before the bankruptcy filing. A bankruptcy discharge can eliminate personal liability for a qualifying tax debt without necessarily eliminating a valid prepetition federal tax lien. If the IRS properly filed a Notice of Federal Tax Lien before bankruptcy, the lien may continue to attach to property covered by the lien even after the debtor’s personal liability for the tax has been discharged.

That distinction matters if you own a home or other property that is subject to a federal tax lien. Reviewing IRS transcripts and lien records before filing can help determine whether a tax debt may be discharged and whether a lien could continue to affect property after bankruptcy.

What About Michigan State Tax Debt and the Michigan Department of Treasury?

Michigan state income tax debt is subject to the federal Bankruptcy Code’s rules governing priority and dischargeability. Whether a particular Michigan tax liability qualifies for discharge depends on the type of tax, the applicable return and assessment dates, and the requirements of 11 U.S.C. §§ 523(a)(1) and 507(a)(8). For Michigan income tax debt, the same general timing rules that apply to qualifying federal income tax debt may allow an older tax liability to be discharged, but the specific dates and circumstances still need to be reviewed.

The Michigan Department of Treasury handles collection for state income tax, sales tax, and use tax debt, and it can pursue liens, levies, and wage garnishments similar to the IRS. Once the Michigan Treasury receives notice of a bankruptcy case, its Bankruptcy Unit handles the state’s tax claims. The Treasury may file a proof of claim when appropriate, and the claim can affect how Michigan tax debt is treated in a Chapter 13 plan.

Certain taxes that the debtor was required to collect or withhold for the government are generally not dischargeable. This can include payroll withholding taxes and certain Michigan sales or use tax liabilities for which the debtor is personally liable. The exact treatment depends on the type of tax and the circumstances that created the liability.

Will Filing Bankruptcy Stop the IRS From Collecting on My Michigan Tax Debt?

Filing bankruptcy triggers the automatic stay under 11 U.S.C. § 362, which generally stops collection efforts for prepetition tax debts by the IRS and Michigan Treasury while the case is pending. This can stop actions such as tax levies and other collection enforcement against the debtor.

There are limits, though. The automatic stay does not prevent the IRS from conducting an audit, requesting a tax return, issuing a notice of deficiency, or assessing a tax. A valid federal tax lien recorded before the bankruptcy filing may also continue to attach to property covered by the lien. Once the bankruptcy case closes, if the tax debt was not discharged, collection generally can resume.

What Happens to a Tax Refund During Bankruptcy in Michigan?

A tax refund may become property of the bankruptcy estate, particularly when it relates to income or tax overpayments attributable to a period before the bankruptcy filing. In a Chapter 7 case, the trustee may be able to claim a portion of an anticipated refund for the benefit of creditors, unless the refund is protected by an applicable exemption.

Michigan debtors may elect the applicable Michigan exemptions or, when permitted, the federal exemptions under 11 U.S.C. § 522. Michigan does not have a general wildcard exemption under MCL 600.5451, so a tax refund should not automatically be described as protected by a wildcard exemption. Whether a particular refund can be protected depends on the applicable exemption and the circumstances of the refund.

Because exemption planning around a refund can get detailed fast, the timing of a bankruptcy filing and the source of an expected refund can matter quite a bit. Reviewing the refund and available exemptions before filing can help determine whether some or all of it may be protected.

Chapter 13 and Tax Debt – a Different Path

Chapter 13 bankruptcy gives Michigan residents a repayment plan lasting several years, and it handles tax debt differently than Chapter 7. Priority tax claims generally must be paid in full through the plan. Bankruptcy can stop most collection activity while the case is pending, but it does not necessarily eliminate interest or penalties associated with non-dischargeable tax debt. Post-petition interest on certain non-dischargeable tax obligations may remain owed even after the bankruptcy case is completed.

Older tax debt that meets the applicable discharge requirements can be treated as a general unsecured claim for purposes of the Chapter 13 plan and may be paid only a portion, or sometimes nothing, depending on the plan and the debtor’s other financial circumstances. The specific classification of each tax claim matters because not all tax debt receives the same treatment in Chapter 13.

For someone who owes several years of income tax and has other debts as well, Chapter 13 can provide more breathing room than trying to manage the debt directly with the IRS or Michigan Treasury outside of bankruptcy. It can also provide a structured way to address tax claims while stopping most collection activity during the case.

Do You Still Have to File Tax Returns During Bankruptcy?

Yes. Filing bankruptcy does not eliminate your obligation to file required federal and state tax returns. Chapter 13 debtors must continue meeting their tax-filing obligations, and certain required returns must be filed before a repayment plan can be confirmed. Current taxes that become due after filing generally must also be paid when they come due.

This matters because missing returns can affect the IRS’s proof of claim and the amount of tax debt that must be addressed through a Chapter 13 plan. If required returns have not been filed, the IRS may file an estimated proof of claim that can later be amended after the returns are filed.

Key Takeaways

• Bankruptcy can discharge some federal and Michigan income tax debt if the applicable timing and other requirements are satisfied, including the three-year, two-year, and 240-day rules in qualifying cases.
• Certain taxes the debtor was required to collect or withhold for the government, including payroll withholding taxes and certain Michigan sales or use tax liabilities, generally cannot be discharged.
• The IRS or Michigan Department of Treasury may file a proof of claim for tax debt in a bankruptcy case. A tax claim can be especially important in determining how much must be addressed through a Chapter 13 plan.
• The automatic stay generally pauses collection efforts for prepetition tax debts while a bankruptcy case is pending, but it does not necessarily prevent audits, tax assessments, or valid tax liens from continuing to affect property.
• Chapter 13 can provide a structured way to repay priority and other nondischargeable tax debt over time, but interest and penalties associated with nondischargeable tax obligations may still remain owed.
• A tax refund attributable to a period before filing may become part of the bankruptcy estate. Whether the refund can be protected depends on the applicable exemption and the circumstances of the refund.
• Filing bankruptcy does not eliminate the obligation to file required tax returns or pay current taxes that become due after filing.
• Debt discharged through bankruptcy is generally not treated as taxable cancellation-of-debt income.

Frequently Asked Questions

Q. Can bankruptcy discharge tax debt in Michigan if I never filed a return for that year?

A. Not necessarily, but failing to file a required return can prevent the tax from being discharged. Federal bankruptcy law imposes specific filing requirements, and the treatment of a late-filed return can depend on when and how it was filed and other circumstances. The filing history for that tax year should be reviewed before determining whether the debt is dischargeable. 

Q. Does the IRS file a proof of claim in every bankruptcy case?

A. Not necessarily. The IRS may file a proof of claim when federal tax debt is owed. In Chapter 13 cases, the IRS may also file an estimated proof of claim when required returns have not been filed. Whether the IRS files a claim and how that claim is treated depends on the circumstances of the bankruptcy case.

Q. What is the Chapter 7 tax debt discharge rule most people rely on?

A. The 3-2-240 rule is a common shorthand for the timing requirements that can apply to federal income tax debt. Generally, the return must have been due at least three years before the bankruptcy filing, the return must have been filed at least two years before filing, and the tax must have been assessed at least 240 days before filing. Certain events can extend or toll these periods, and fraud or a willful attempt to evade or defeat the tax can also prevent discharge.

Q. Can I discharge Michigan sales tax debt in bankruptcy?

A. Not necessarily. Certain Michigan sales or use tax liabilities that the debtor was required to collect or withhold for the government may be treated as nondischargeable under federal bankruptcy law. The treatment depends on the type of tax and the circumstances that created the liability, so it should not be assumed that every Michigan sales or use tax debt receives the same treatment.

Q. Will filing bankruptcy remove an existing IRS tax lien on my house?

A. Not necessarily. Filing bankruptcy may discharge personal liability for qualifying tax debt, but a valid federal tax lien recorded before bankruptcy can survive the bankruptcy and remain enforceable against property to which the lien attached. A discharge of personal liability does not necessarily eliminate the lien’s effect on property.

Q. Should I wait to file bankruptcy until after I get my tax refund?

A. Timing can matter because a refund attributable to a prepetition tax period may become property of the bankruptcy estate. Whether the refund can be protected depends on the applicable exemption and the facts surrounding the refund. It is worth reviewing an expected refund before filing rather than assuming it will automatically be protected.

Ready to Talk Through Your Tax Debt and Bankruptcy Options?

Tax debt does not have to sit on your shoulders forever, and it does not have to dictate every financial decision you make. Whether you are dealing with an IRS balance, a Michigan Treasury bill, or both, the attorneys at Hammerschmidt Stickradt & Associates can review your tax years, filing history, assessment dates, and overall financial situation to help determine whether Chapter 7 or Chapter 13 may offer a path forward.

If you are considering bankruptcy and want to understand how your tax debt may be treated, contact Hammerschmidt Stickradt & Associates to schedule a free consultation. The right approach depends on the type and age of your tax debt, your other financial obligations, and your goals, so getting advice based on your specific circumstances can help you understand your options and what a fresh financial start could look like for you and your family.