Tax Discharge and Bankruptcy for Attorneys

How to get Federal and New York State taxes discharged in bankruptcy

One common myth regarding bankruptcy is that taxes cannot be discharged. While it is true that most taxes are non-dischargeable, through a rather complicated analysis, many taxes actually are dischargeable through bankruptcy. This will first focus on the taxes that are absolutely non-dischargeable in bankruptcy, and will then shift to discuss the different rules that can enable a tax discharge through bankruptcy.

Non-Dischargeable Taxes in a chapter 7 or 12 case

  • If a tax return, or equivalent report or notice, was never filed.
  • If a fradulent return was filed
  • If the debtor willfully attempted to evade the taxing authority to avoid paying taxes
  • If a late return was filed within 2 years of filing of the bankruptcy
  • If the tax is on income or gross receipts and
  1.  There was a return due within 3 years of bankruptcy, or
  2. The tax was assessed within 240 days of filing for bankruptcy, or
  3. The tax has not yet been assessed, but is assessable after filing bankruptcy
  • Any Property tax assessed before a bankruptcy case is filed and was last due without penalty less than one year before the bankruptcy case was filed.
  • Any excise tax on transactions as to which a return was required and due less than 3 years before the bankruptcy case was filed or transactions, where no return was required but occurred less than 3 years before the bankruptcy case.
  • Any other taxes that were required to be collected or withheld by the debtor; for example, employment/”trust fund” taxes, income taxes and FICA withholdings or sales taxes.

Dischargeability of Taxes in Bankruptcy

Typically, the IRS has 10 years to collect on taxes, penalties and interest. Once a bankruptcy case begins, the time the IRS has to collect on the taxes is tolled, meaning the IRS gets the time remaining on the original 10 years plus the time the bankruptcy case is pending, and an additional 6 months after the bankruptcy case is finished.

Chapter 7 Bankruptcy and Tax Discharge 

Income taxes that meet the following guidelines are dischargeable in bankruptcy:

  1. 3-year rule: The tax return must have been due at least 3-years before the bankruptcy is filed.
  2.  The 2-year rule: The tax return was “filed” at least 2 years before the chapter 7 Bankruptcy was commenced. For the purposes of the filing requirement, a return is considered to be “filed” when the debtor participates in or signs off on a return)
  3. The-240 Day Rule: The taxes were assessed by the IRS at least 240 days before a bankruptcy is filed. A tax is considered to be assessed on the date the IRS notifies the taxpayer that there is a tax claim or on the date that the tax assessment officer signs a summary record of assessment. The IRS can assess a tax return within 3 years of when a return is filed or the last day a tax return is due (which ever occurs later).  When an amended return is filed there is a new 240 day period that begins for additional taxes to be assessed. Similarly, if a substitute return is filed by the IRS on the debtor’s behalf, the assessment period does not begin.  If an offer and compromise is made the 240 day period is extended while it is pending/in effect plus 30 days.  A prior bankruptcy will extend the 240 day period for the period the collection was stayed plus 90 days.
  4.  If there was fraud involved in preparing the tax return or a willful attempt to evade paying taxes the tax debt is also non-dischargeable.

The best way to determine what taxes, if any, will be dischargeable is to obtain tax transcripts for each year in question from the IRS. Essentially, once the tax is determined to be dischargeable and a chapter 7 bankruptcy discharge is obtained, the personal obligation to pay these taxes is wiped out.

Tax Liens

Another issue will be whether the IRS has obtained a tax lien. If such a lien is in place before a chapter 7 is filed, then the IRS can still go after anything that is part of the estate after a discharge is gotten. Even exempt assets (such as exempt equity in a car or home, retirement accounts, etc.) can be sought by the IRS after a discharge is granted. However, the tax lien survives only to the extent of the value of the debtor’s equity in the property at filing. So if the estate has $10,000 worth of exempt  equity on the date of filing and the IRS has a tax lien of $250,000, the value of the tax lien will only be $10,000 after filing. Things like clothing, furniture and personal items are usually exempt from tax liens. Also, the IRS lien will not attach to public benefits such as Social Security and workers compensation. Tax liens can be discharged in a Chapter 13 Bankruptcy.

Chapter 13 and Tax Discharge

In a Chapter 13 bankruptcy, the debtor will list the amount of debt that is considered to be priority debt and dischargeable debt. Priority debt must be paid through the chapter 13 plan (over 3 or 5 years). Once the case is filed, the IRS will file what is called a proof of claim stating the portion of the tax debt that is priority and the portion that is dischargeable. If the IRS fails to file a timely proof of claim, then nothing is required to be paid back to the IRS, and any tax debt is dischargeable (except tax liens, as discussed earlier).

Filing Chapter 13 stops all interest and penalties when the petition is filed.

In Chapter 13, tax liens can be extinguished if the plan is completed.

Often referred to as a “Chapter 20 Bankruptcy”, the debtor files Chapter 7 to wipe out any dischargeable taxes and then files Chapter 13 to pay back the non-dischargeable amount. The interest and penalties are stopped when the 7 is filed. It is called a Chapter 20 because 7 + 13 =20.

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 are followed in New York State as are for Federal tax dischargeability.