First, it is important to understand how a bankruptcy filing works. For individuals or married couples there are 2 main types of filings in New York. This first, and most common, is chapter 7 or “Liquidation Bankruptcy”. When an individual or couple files for chapter 7 a bankruptcy “estate” is created. This covers everything owned by the filer(s). Next, the court looks at what are called exemptions. Exemptions protect the “equity” or value the filer has. An example would be a home. Let’s say John owns a house worth $400,000. His mortgage is $300,000. So, $400,000 – $300,000 = $100,000, so John has $100,000 in equity in his house. If John sold the house he would pay off his mortgage with $300,000 and get to keep the extra $100,000 (John’s equity in the house). Now let’s back up just a bit to the second that John files for Bankruptcy. When he files, there is what is called an automatic stay on the estate. This means no one can touch anything in the estate as long as the “stay” is in place. Essentially, no one, not even the IRS can touch John’s stuff, or even question John about it. At this point, if the IRS wants to try and collect money from John, they need to go to court and ask a judge to lift the stay. It is rare that a judge will do this because the IRS must show that John has committed fraud.
Now let’s look at some of the rules to see whether John will owe back for taxes after his bankruptcy case is finished, or “discharged”. First, there is a 10 year time period for the IRS to collect taxes from John. However, since John has filed for bankruptcy, the IRS gets extra time—also known as “tolling”—to try and collect back taxes from him. In other words, once his bankruptcy case is finished, the IRS is alloted whatever time was left on the original 10 years, plus the additional time that the bankruptcy case was pending (usually around 5 months for a chapter 7) plus an additional 6 months.
- Now let’s see what tax debt will be erased after John’s filing is completed. In order for his debts to be erased, they need to be due at least 3 years before he filed. Essentially the return for the tax debt we are analyzing must have been due at least 3 years before John declared bankruptcy.
- The tax return must have actually been filed at least 2 years before the chapter 7 began. In order to be considered “filed”, John must have either prepared, signed and sent his return to the IRS or participated in helping the IRS complete his return. Substituted returns, where the IRS files a return without John’s knowledge, do not count.
- Next the tax must have been assessed more than 240 days before the bankruptcy was filed. The IRS must have either notified the taxpayer that there is a tax claim, or a tax officer must actually summarize and file John’s assessment for the 240 day period to start. The IRS is allowed to “assess” a tax return within 3 years of when a return is filed, or the last day the tax return is due (whichever is later).
- If John lied (committed fraud) when he prepared his return, or tried to evade the IRS the tax debt is also non-dischargeable. This is very rare and usually the IRS does not go after people for this.
The best way to decide whether John’s taxes are dischargeable is by getting tax transcript from the IRS, which usually contains the information needed to determine if the taxes can be wiped out.
Now let’s assume that John has owed this tax money for some time, and the IRS has put a tax lien on John’s property. A tax lien is where the IRS files a claim on John’s stuff with the county court where John lives. The lien is based on his owed taxes. If there is a tax lien on John’s property, then even after bankruptcy is finished, the IRS can still go after anything that John owned before he filed for Bankruptcy. This even includes the $100,000 in equity on his house that we discussed earlier. It is exempt and John gets to keep it through bankruptcy from all of his creditors—credit card issuers, doctors he owes money to, etc.—but the IRS can still go after the $100,000 in equity. But let’s say that years after John’s bankruptcy was finished, he bought another house and had $150,000 in equity in that second house, then the tax lien would still allow the IRS to go after the equity in the first home. However, the IRS cannot touch the $150,000 in equity in the second home because it was not owned by John when he first filed for bankruptcy. Also, things like John’s clothing, furniture and other personal items are usually protected from IRS tax liens. Similarly, any public benefits like Social Security or workers compensation are protected from tax liens.
Now let’s look at Chapter 13 and taxes. Chapter 13 bankruptcy is where John makes a 3 or 5 year payment plan based on his leftover income each month (John’s “disposable income”). In a Chapter 13 filing, John makes monthly payments to the “trustee” appointed by the court who uses the money to pay some of John’s debts back. Usually, John gets the same discharge after finishing a Chapter 13 payment plan. Taxes which do not pass the test that we went over earlier are considered to be “priority” debts and must be paid in full through the Chapter 13 plan. In a Chapter 7 filing, the “priority debts” are usually still owed after the bankruptcy is finished. Chapter 13 stops interest and penalties when the petition is filed, and tax liens can be extinguished when the 13 plan is completed.
New York State Income Tax And Bankruptcy
For the most part, state income taxes can be discharged in exactly the same way that federal taxes are. The same rules to determine whether taxes can be discharged or not are followed both in New York State as well as for federal taxes.