Penalties can be a huge part of an IRS balance. Failure to file, failure to pay, accuracy penalties, and sometimes fraud penalties, all with interest on top. When people think about bankruptcy, they lump the whole balance together.
The Bankruptcy Code does not. It treats penalties under a different set of rules than the tax, and those rules are often friendlier to you.
The main rule: 11 U.S.C. § 523(a)(7)
Section 523(a)(7) excepts from discharge a fine, penalty, or forfeiture payable to a governmental unit that is not compensation for actual pecuniary loss. Then it carves out tax penalties. A tax penalty is dischargeable if either of these is true:
- (A) it relates to a tax that is itself dischargeable, or
- (B) it was imposed with respect to a transaction or event that occurred more than three years before the petition date.
Notice the word "or." Either test is enough. That second test is where the value is.
Test A: the tax is dischargeable
This one is intuitive. If the underlying income tax meets the timing rules and is discharged, the penalties on it go with it. If you are wiping out an old year under the three-year, two-year, and 240-day rules, the penalties for that year fall too. Start with the 3-year rule.
Test B: the event is more than three years old
This is the part people miss. Even if the tax itself survives, a penalty can be discharged if the transaction or event that triggered it happened more than three years before you filed.
The Eleventh Circuit, which covers Florida, applied this plain reading in In re Burns, 887 F.2d 1541 (11th Cir. 1989). The IRS argued the statute should be read to keep penalties nondischargeable whenever the tax was nondischargeable. The court refused, read § 523(a)(7) at face value, and affirmed the ruling that the debtor's fraud penalties for the older years were discharged.
So a debtor with an unfiled year from long ago may still owe the tax under § 523(a)(1)(B), but the penalties on that old year may be discharged under § 523(a)(7)(B). Courts can differ on what counts as the "transaction or event" for a particular penalty, so the analysis has to be done penalty by penalty and year by year.
Penalties are usually not priority claims
Priority matters for how much gets paid. 11 U.S.C. § 507(a)(8)(G) gives priority only to a penalty related to a priority tax claim and in compensation for actual pecuniary loss. Most IRS penalties are punitive, not compensation for loss.
The IRS's own manual agrees on classification. IRM 5.9.13.19.4 says penalties where the IRS did not suffer an actual loss, and interest associated with those penalties, are classified as general unsecured claims. The IRM also notes that interest on a penalty is always classified as a penalty. Read priority vs general unsecured tax claims for why that classification matters.
Chapter 7: penalties go to the back of the line
In a Chapter 7 case with assets to distribute, 11 U.S.C. § 726(a)(4) pays claims for fines and penalties that are not compensation for actual pecuniary loss only after priority claims and ordinary unsecured claims. In most cases, that means the penalty portion of an IRS claim receives little or nothing from the trustee.
That subordination is separate from discharge. A penalty that is not dischargeable under § 523(a)(7) still survives the case even if the trustee paid nothing on it.
Chapter 13: an even broader discharge for penalties
Chapter 13 has its own list of debts that survive a discharge granted after you complete the plan. 11 U.S.C. § 1328(a)(2) excepts taxes described in § 507(a)(8)(C) and debts in specific paragraphs of § 523(a), including (1)(B) and (1)(C). Paragraph (7) is not on that list.
In other words, after a completed Chapter 13 plan, a penalty that was provided for by the plan or disallowed may be discharged even if it would have survived a Chapter 7 under § 523(a)(7). Because penalties are general unsecured claims, the plan may pay them only a small percentage. Note that a hardship discharge under § 1328(b) does not get this benefit; § 1328(c)(2) excepts every debt of a kind specified in § 523(a).
Compare the two chapters for your whole picture in Chapter 7 vs Chapter 13 for tax debt.
Penalties stop growing during the case (mostly)
IRC § 6658 generally bars the IRS from adding failure-to-pay and estimated tax penalties under IRC §§ 6651, 6654, and 6655 on pre-petition taxes for the period the case is pending, in the situations the statute describes. The exception is penalties on taxes withheld or collected from others, such as trust fund taxes, under § 6658(b).
IRM 5.9.4.14 explains how the IRS applies this: the penalty is suspended from the petition date and resumes from the date the case is dismissed or closed on nondischargeable liabilities. If your case is dismissed, the meter starts again. See what a dismissed bankruptcy does to your tax debt.
The Trust Fund Recovery Penalty is the exception
Do not assume everything named "penalty" gets penalty treatment. The Trust Fund Recovery Penalty is treated as a tax. IRM 5.9.13 states that it is never listed as a general unsecured claim, citing United States v. Sotelo, 436 U.S. 268 (1978). It is a priority claim under § 507(a)(8)(C), and § 1328(a)(2) keeps it alive even after a completed Chapter 13. Details are in trust fund taxes and the TFRP in bankruptcy.
Bankruptcy or penalty abatement?
Bankruptcy is not the only way to deal with penalties. The IRS can abate certain penalties for reasonable cause or first-time abatement, without filing anything in court. Sometimes abatement is the cleaner fix, and sometimes bankruptcy is. The getirshelp.com page on penalty abatement covers the non-bankruptcy route, and our general page on IRS penalties explained simply explains what each penalty is.
If you want your penalties sorted year by year to see which ones bankruptcy could reach, call (813) 229-7100 and talk with a tax attorney. Every case turns on its own transcripts and dates; this page is general information, not legal advice for your situation.
The tax may be stuck to you. The penalty might not be.