Can taxes be discharged in bankruptcy is a question I get frequently.
I have had to have this discussion with a few clients lately because they are in a terrible financial place. We talked about the possibility to discharge some of their tax debt and their other debts in bankruptcy. So I did some research.
I am not an expert in bankruptcy and the thing that brought this post to light is the article written by David Andrews, that gave me the insight to look a little further into the rules of bankruptcy.
In order to qualify for taxes to be dischargeable in bankruptcy, it has to meet 3 or 4 rules.
The first one is the 3-year rule. The taxes must have been due at least 3 years ago in order to become dischargeable. Meaning that a 2018 return would have been due on April 15, 2019. 3 years from that would be April 15, 2022. If there was an extension filed, it would be October 15, 2022, to meet the 3-year rule. Pretty simple so far.
The next rule is the 2-year rule. This one is a little trickier. The return must have been filed at least 2 years ago in order for it to become dischargeable. The question is, what is considered a return and what is considered filed? The courts have realized that a late re-filed return may not be a “return” and if it was ever a Substitute for Return where the IRS prepared the return for you, it may also not be dischargeable. So, there are some little things that would need to be reviewed
The next thing is the 240-day rule. This means that the taxes must have been assessed at least 240 days ago. If there was an audit that happened 3 months ago, you would have to wait another 5 months (240 days), about 8 months in order for that tax to become dischargeable.
Here is some additional information regarding taxes and bankruptcy. Further, I’d like to again thank David Andrew from IRS Solutions for writing this great article.
Will bankruptcy eliminate tax debt?
Falling into debt can carry heavy emotional and social burdens in addition to financial hardships. Different solutions exist and one viable option may be bankruptcy, but that too can be shrouded in mystery. Filing bankruptcy can discard some debts (referred to as discharging) or formalize a manageable repayment plan. Specifics regarding tax liabilities and potential discharge of tax debts are subject to the many clauses of the United States Bankruptcy Code. Read more about tax debt forgiveness below.
Some taxes may be dischargeable
Bankruptcy does not automatically exonerate debtors from all debt liabilities but the bankruptcy court may discharge debts, including taxes. A court-ordered discharge permanently prohibits creditors from taking any further action against the debtor to collect certain specified types of debt. Additionally, debt canceled in a bankruptcy proceeding is not treated as income (although it does reduce other tax benefits if any were entitled). IRS Publication 908 outlines taxes that are not subject to discharge under Chapters 7, 11, 12, and 13.
Determine which tax debts may be discharged
Dischargeability may be determined by understanding your client’s particulars and if your client is subject to any of the 19 categories of exceptions under paragraph 523(a) of the Bankruptcy Code. While taxes that are inherently for the benefit of someone else (e.g. trust fund taxes) or penalties for fraudulent activities cannot be discharged by law, some taxes (e.g. income taxes meeting criteria) may be dischargeable. Four initial rules can help to determine if a tax debt may be discharged:
Assessment is at least 240 days old
The Tax return was filed at least 2 years ago
Tax return due date must be at least 3 years old (plus extensions). SFR (Substitute for Return) cannot have been filed on behalf of the client prior to bankruptcy (There are different opinions in the various courts. Please check with a qualified attorney in your district.)
The scope of a bankruptcy discharge is dependent on the Chapter under which the bankruptcy is filed as well as the nature of the debt.
Federal tax liens in bankruptcy proceedings-
Exposure to federal tax liens is affected by multiple codes and subject to different levels of priority under the specific Chapter of bankruptcy filed. Federal tax claims not secured by a Notice of Federal Tax Lien (NFTL) filed before the bankruptcy petition might be able to be discharged. Federal taxes that are more than three years overdue may be dischargeable barring extenuating criteria.
Proof of Claim-
Proof of Claim Forms must generally be filed by creditors, including the IRS, to receive funds. The debtor must notify creditors of the pending bankruptcy and it is considered “timely” if provided at least 30 calendar days prior to the deadline (also known as the bar date). If your client filed late or missed filing a claim completely, the circumstances under which the IRS may still demand payment become subject to the commencement of final distribution or filing of a special post-petition administrative claim by the IRS, and could possibly be disallowed.
Different rules apply to the payment of taxes not discharged, generally ranging from immediate payment in Chapter 7 bankruptcy (as long as assets suffice) to 3-5 years in Chapters 11 and 13 filings. During repayment periods it is essential that your client keeps current with all subsequent tax returns and is up to date on associated obligations.
Don’t go it alone. You need to figure out which of the rules applies to your situation. You need to talk to an expert.