Most taxes can't be eliminated in bankruptcy, but many older, unsecured income taxes can be.
If your clients have heard commercials offering the hope of eliminating tax debts in bankruptcy, make sure to alert them that it's not as simple as it sounds. Most tax debts can't be wiped out in bankruptcy—they'll continue to owe them at the end of a Chapter 7 bankruptcy case or have to repay them in full in a Chapter 13 bankruptcy repayment plan. In this article, I'll discuss:
- when you can discharge a tax debt
- what happens with federal liens, and
- how to manage tax debt using Chapter 13.
You’ll also read about the pros and cons of filing tax returns before or after bankruptcy.
When You Can Discharge Tax Debt
If you need to discharge tax debts, Chapter 7 bankruptcy will be the better option—but only if the tax debt qualifies for discharge (not all do) and your client is eligible for Chapter 7 bankruptcy. All of these conditions must be met before you can discharge (wipe out) federal income taxes in Chapter 7 bankruptcy:
- The taxes are income taxes. Taxes other than income, such as payroll taxes or civil penalties (e.g. Trust Fund Recovery Penalties), can never be eliminated in bankruptcy. (Well, the non-trust fund portion of an unincorporated employer (e.g. a sole proprietor) can be discharged if the other tests are satisfied).
- They did not commit fraud or willful evasion. If your client filed a fraudulent tax return or otherwise willfully attempted to evade paying taxes, such as using a false Social Security number on their tax return, bankruptcy can't help.
- The return was “due” at least three years ago. The tax return must have been originally due (including extensions) at least three years before filing for bankruptcy, regardless of when the return was actually filed.
- Your client filed a tax return. They must have actually filed a tax return and it must have been filed at least two years before filing for bankruptcy. (In most courts, if a late return is filed (meaning the extensions have expired and the IRS filed a substitute return on their behalf), they have not filed a "return" and cannot discharge the tax. In some courts, you can discharge tax debt that is the subject of a late return as long as your client meets the other criteria.)
- Your client passes the "240-day rule." The IRS must have assessed the income tax debt at least 241 days before a bankruptcy petition is filed, or not at all. (This time limit could be extended if the IRS suspended collection activity because of an offer in compromise.)
Some jurisdictions have additional requirements, too. For instance, in the First, Fifth, and Tenth Circuits, a tax return must be filed in a timely fashion. Filing late, even one day late, precludes a discharge automatically. This is known as the McCoy Rule but the good news is, the IRS does not follow the McCoy Rule so you only have to worry about the McCoy Rule for discharging state income tax debts.
Last, we recommend you not file an Adversary Proceeding seeking a court order that the taxes were eliminated. Rather, wait 60 days after the Discharge is entered and then call the Insolvency Unit at 800-973-0424, confirm they acknowledge the tax debts were discharged, and that the lien will be released. Ask for updated Account Transcripts to be sent to your client showing “zero” balances due. You might need a form 2848 to do this (available at IRS.gov).
This is the first part of a 3-part article on eliminating income taxes in bankruptcy. Parts 2 and 3 will be featured in upcoming TDD newsletters. If this article raises any issues or questions that you'd like to discuss – or if you have any questions about the TDD tool in general, please feel free to email me at larry@taxdischargedeterminator.tax or you can call me at 833-879-9210.