You Can Discharge Income Taxes in Bankruptcy
There is a common misconception that income taxes are never dischargeable in bankruptcy. In fact, you can discharge your back federal, state, and local income taxes in Chapter 7, Chapter 13, and Chapter 11. Penalties and interest are also dischargeable. Determining which back taxes are dischargeable can be a little complex. However, it is possible to discharge significant income tax debt in bankruptcy, if your tax debt fits within the following rules:
The 3 Year, 2 Year, and 240 Day Rules. The Bankruptcy code sets out specific time periods that determine if you can discharge your taxes. Under these rules, you can discharge those income taxes for which the tax return was due more than 3 years before the bankruptcy petition is filed, as long as it has been more than 2 years since you filed the income tax returns and more than 240 days, plus any time an offer in compromise was pending plus 90 days, since the income taxes were assessed. These rules are complicated and are often misunderstood. The important thing to understand is that you must meet the requirements of all three rules to discharge your taxes.
1. The 3-Year Rule. This rule states that to discharge delinquent income taxes, the due date for filing the income tax return must be more than three years before you file for bankruptcy. Bankruptcy Code §507(a)(8)(A)(i). Typically, your federal and most state income taxes become due on or around April 15th of each year but if you filed an extension the due date will be later (on or around October 15 for federal income taxes). In most cases, it is simply a matter of adding three years to this due date to determine the earliest date you can file for bankruptcy and still discharge your taxes.
Example: Joe’s 2008 federal income taxes are due on April 15, 2009. If Joe owes taxes for that year and wants to discharge them, the earliest he can file for bankruptcy is April 15, 2012 (April 15, 2009, plus 3 years).
Example: If Joe in the example above obtains an extension until October 15, 2009, his tax due date is October 15th, not April 15th. Therefore, he must wait until October 15, 2012 to file for bankruptcy, if he wishes to discharge these taxes.
2. The 2-Year Rule. Under the 2-year rule, your income tax returns must have been filed by the taxpayer more than two years before filing your bankruptcy petition. This requirement allows you to discharge your taxes, even if you filed your tax forms late, as long as you file them at least two years before filing for bankruptcy. §523(a)(1)(b)(ii). However, if the IRS filed a substitute tax return for you then the income taxes may not be dischargeable but the penalties and interest on the penalties would be dischargeable.
Example: Jill’s income taxes were due on April 15, 2009. Jill did not get an extension. However, she did not get around to filing her tax forms until June 1, 2010. If Jill wants to discharge her 2009 taxes, she cannot file for bankruptcy until June 1, 2012 (two years from the date she filed her taxes AND more than three years from the date the taxes were due).
What if you did not file? If you did not file an income tax return in a given tax year, any taxes assessed by the IRS for that year are not dischargeable. §523(a)(1)(b)(i). In my Austin, Texas bankruptcy practice, I sometimes see clients whose taxes would have been dischargeable, if only they had filed their tax forms. If their tax debt is significant, I may advise them to go ahead and file the tax forms, then wait to file for bankruptcy.
Quick Point: If the IRS files a return on your behalf, it is not considered a filed return for the purposes of this rule. You must still file a tax form for that year.
3. The 240-Day Rule. Taxes must be assessed at least 240 days before you file for bankruptcy under this rule. As a practical matter, the date of assessment is typically on or near the date you filed your income tax form (assuming the IRS and you agree on the amount of taxes owed). However, if you file a correction or a change results from an IRS audit, the assessment date may be substantially later. §507 (a)(8)(A)(ii)
Example: Joe filed his 2009 taxes on April 15, 2009. His taxes are assessed by the IRS on the same day. Joe meets the requirements of the 3-2-240 rules on April 15, 2012. However, if Joe files a correction on January 1, 2012, the 240-day clock starts over. Therefore, he cannot file for bankruptcy until August 28, 2012 (January 1, 2012, plus 240 days), if he wants to discharge these taxes.
Example: Jill files her 2009 taxes on time on April 15, 2009. The IRS audits Jill’s taxes and finds that Jill made a mistake. She actually owes a few hundred dollars more than shown on her original tax form. The IRS assesses the new amount along with some penalties and interest on March 1, 2011. To discharge her 2009 taxes (and the penalties and interest) Jill will have to wait until October 27, 2012 to file for bankruptcy (240 days from the IRS’s new assessment).
If you are in a dispute with the IRS regarding how much you owe and plan to file for bankruptcy, you should inform your bankruptcy lawyer of the dispute. A tax dispute can impact the assessment date.
Other actions can add additional time to some or all of the 3-2-240 time requirements, including (a) making an offer in compromise, (b) having filed for bankruptcy previously, or (3) obtaining a taxpayer assistance order. §507(a)(8)(A)(i).
Quick Note: If the back taxes are an issue, it may be necessary to order an IRS “account transcript” (sometimes called a “literal transcript”) for the tax years in question. The account transcript typically includes the assessment date. Note that this is not the same as a “tax return transcript”. You can order an account transcript from the IRS over the phone or online, or using IRS Form 4506T.
Post-Bankruptcy Tax Assessments are Not Dischargeable
A taxing authority is legally permitted to start or continue a tax audit and assess additional tax after a taxpayer files for bankruptcy, if the time period for assessing additional tax has not expired. A tax that is assessed after the bankruptcy is filed is not discharged. The IRS generally has three years from the date a taxpayer files an income tax return to audit a return and assess additional tax. Therefore, if the taxpayer has satisfied the first condition above then more than three years will have elapsed between the date the income tax return was due, including extensions, and the date that the bankruptcy petition is filed, and the IRS cannot legally assess any additional tax for years that were discharged in the bankruptcy, with three exceptions.
The first exception is that, if a tax return omits gross income by more than 25%, then the IRS has 6 years from the return filing date to assess the additional tax. The second exception is that if the taxpayer files a fraudulent return or is guilty of tax evasion, then the IRS can assess the additional tax at any time. The third exception is when the taxpayer signs a written agreement extending the deadline. Therefore, the rule preventing a bankruptcy discharge of taxes assessed after the bankruptcy filing date will only occur in those situations where IRS can prove that the taxpayer filed a return omitting gross income by more than 25%, filed a fraudulent return or is guilty of tax evasion, or signed a written agreement extending the deadline.
Fraudulent Tax Returns are Not Dischargeable
A tax debt is not dischargeable if the taxpayer files a fraudulent tax return. A tax return is fraudulent if the taxpayer intentionally fails to report income or makes misrepresentations on the tax return. Further, if a taxpayer willfully attempts to defeat or evade payment of a tax then the tax is not dischargeable in bankruptcy. The tax fraud issue may be raised after the bankruptcy case is closed. If a taxpayer has the ability to pay the tax but uses the funds for other purposes or if the taxpayer evidences a pattern of failing to file tax returns, failing to pay taxes, or attempting to hide income and assets then the taxpayer may be guilty of tax evasion and the taxes would not be dischargeable.
Payroll or employment taxes are comprised of the employer portion and the employee portion. The employer is required to withhold the employee portion from the employee’s pay check and remit it to the IRS.
• Trust Fund Portion of Payroll Taxes is Never Dischargeable. The employee paid portion of the payroll tax includes the 6.2% social security tax and the 1.45% Medicare tax. The employee portion of the tax is referred to as a “trust fund” tax because the employer is collecting the employee paid portion of the payroll tax from the employee in the capacity of a trustee for the IRS. Trust fund taxes are never dischargeable in bankruptcy. A Chapter 13 plan must provide for full payment of all trust fund recovery taxes in order to be confirmed. There is no escape from trust fund recovery taxes. The tax will become uncollectible if the 10 year statute of limitations expires without the IRS filing suit, regardless of whether the taxpayer files bankruptcy or not.
• Employer Portion of Payroll Taxes is Dischargeable – Sometimes. The employer portion of the payroll tax is the tax which the employer owes directly to the IRS. The employer portion includes the employer’s obligation to match the employee’s 6.2% social security tax and the 1.45% Medicare tax. The employer portion of the employment tax can be discharged if (1) more than three years pass between the date the 941 tax return was last due, including extensions and the date that the bankruptcy was filed; (2) more than two years pass between the date the 941 tax return was filed and the date the bankruptcy case was filed; and (3) the taxpayer did not willfully evade payment of the tax.
Sales Taxes are Not Dischargeable in Texas
A sales tax is a tax collected from a customer by a seller of goods or services. Sales taxes are classified as trust fund taxes in Texas because the business is required to collect the tax from the customer in the capacity of a trustee for the state. Trust fund taxes are never dischargeable in bankruptcy. A Chapter 13 plan must provide for full payment of all trust fund recovery taxes in order to be confirmed. There is no escape from trust fund recovery taxes.
Personal Liability for Sales Taxes as Trust Fund Taxes in Texas
An individual is personally liable for non-payment of a sales tax is he (1) controls or supervises the collection of the tax from a customer; or (2) supervises the accounting and payment of the tax to the state and willfully fails to pay the funds to the state. Any owner or employee of a business who either collects or supervises the collection of the tax, or who is responsible to pay the bills and willfully fails to pay the state will be personally liable for payment of the tax if it is not paid.
Property Taxes are Dischargeable – Sometimes
A property tax is a tax imposed upon a person by virtue of his ownership of property. Real estate taxes levied upon land owners by local municipalities and personal property taxes levied against business owners by local municipalities for ownership of personal property used in connection with a business are the two types of property taxes in Texas. Property taxes are dischargeable if the tax was incurred before the commencement of the case and was last payable without penalty more than one year before the bankruptcy petition was filed. Remember, however, that liens survive bankruptcy. Property taxes are secured with a statutory lien against the property that the tax is assessed against. Therefore, if you want to keep the property that the property tax was assessed against, you must pay the property taxes even if the debt is discharged in bankruptcy or the taxing authority can foreclose on the property.
Penalties and Interest on Taxes are Dischargeable – Sometimes
Interest and penalties on federal tax debts are dischargeable if the underlying tax is dischargeable. In a Chapter 7 case, if the federal tax is not dischargeable because it relates to a tax year where the due date for filing the tax return is less than three years before the bankruptcy was filed, then the penalty relating to the unpaid tax is not dischargeable. In a Chapter 7 case, if the events giving rise to the penalty occur more than three years before the taxpayer files for bankruptcy, then the penalty is dischargeable even if the related tax is not dischargeable. Therefore, penalties on trust fund taxes, taxes assessed within 6 years after a tax return was filed because gross income was under reported by more than 25%, and taxes owed because a taxpayer filed a fraudulent return or is guilty of tax evasion, are dischargeable even though the underlying tax is not dischargeable. The interest on these types of taxes is not dischargeable but the interest assessed on the dischargeable penalty is abated.