If there’s one thing that the government wants, it’s the revenue it collects for taxes.  Not surprisingly, when it comes to bankruptcy, the government has ensured that it is a “preferred” creditor – so to speak.

In general, taxes that are less than 3 years old are nondischargeable, as are tax debts where the debtor has engaged in some sort of deception (failure to file returns, attempting to evade taxes, failing to withhold employee taxes (so-called trust fund taxes), etc.

Relatedly, § 523(a)(7) of the Bankruptcy Code makes a “fine, penalty, or forfeiture payable to and for the benefit of a governmental unit” nondischargeable.   Thus, where the government has imposed some sort of penalty for nonpayment of taxes then the penalties are generally not dischargeable as well.

§ 523(a)(7) applies in Chapter 7 cases, rendering most tax penalties nondischargeable.

However, there is an exception where the debtor files for Chapter 13 bankruptcy.  The Chapter 13 discharge provisions do not list § 523(a)(7) as one of the provisions that fall within the exceptions to discharge in a Chapter 13 case.

Indeed, the Internal Revenue Service, in a technical memorandum has quite clearly stated that:

“To the extent prepetition tax penalties (and their associated prepetition interest) are not paid pursuant to the Chapter 13 plan, they are dischargeable under B.C. § 1328(a)(2) because that subsection does not include subsection 523(a)(7) among its list of nondischargeable provisions.”

See http://www.irs.gov/pub/irs-wd/1005029.pdf.

So, the short answer is that: (1) tax penalties are very hard to discharge in a Chapter 7 case, and (2) tax penalties are dischargeable in a Chapter 13 case.

The fact that tax penalties are dischargeable in a Chapter 13 case can be a huge incentive for a debtor to file under Chapter 13 – especially where there are numerous years of tax liabilities with large penalties tacked on.