Taxes and Bankruptcy: The Nuts and Bolts

Most people think that filing bankruptcy can’t get rid of taxes. This is not true. Both Chapter 7 and Chapter 13 of the bankruptcy code provide for the elimination of substantial amounts of personal “income” tax liability.

There are certain requirements, but when these requirements are met, taxes can be eliminated as easily as unsecured credit card debt.

What Taxes Are Dischargeable In Chapter 7?

Substantial personal “income” taxes can be eliminated through filing a subsequent discharge of a Chapter 7 bankruptcy. However, to be dischargeable, all of the following requirements must be met. These requirements must be applied separately to each tax year in question:

  1. The only IRS tax that can be discharged is income tax. You cannot get rid of other taxes, for example, withholding taxes.
  2. It must be at least 3 years since the tax return was due. That is, it must be at least 3 years since the last day that the tax return for the year in question could have been filed without being considered overdue. For instance, for the tax year 1999, assuming that you did not get an extension, the 3 year period started on 4/16/2000. If you got an extension to file the return, that would have made your tax return overdue only as of 8/16/2000; in which case you start counting the 3 year period from this date. If you got 2 extensions, the 3 year period would have started on 10/16/2000.
  3. The tax return must have been actually filed at least 2 years before the date the Chapter 7 case is filed. So regardless of when the tax return was due, if you only filed the tax return one year ago, the tax is not dischargeable in Chapter 7.
  4. The tax you are trying to discharge must have been “assessed” by the IRS at least 240 days before the Chapter 7 case is filed. For instance, lets say all the other rules are satisfied, but due to an audit, the IRS makes an additional assessment 100 days before the bankruptcy filing. In this case, the new amount assessed is not dischargeable.
  5. You must not have made a fraudulent return or willfully attempted to even or defeat the tax. This rule is almost never a problem, but it must be kept in mind for that rare case where fraud or tax evasion is in issue.

What about Chapter 13?

In Chapter 13, all the same rules of Chapter 7 apply, except for one. There is no requirement that the tax return be filed. This is an important and crucial distinction. There are many times when a client meets all the other requirements, but either the client did not file the return for the tax year or the client filed but is unable to prove it. This situation comes up a lot in handling bankruptcy cases, making Chapter 13 a valuable tool for the discharge of taxes.

In addition, in Chapter 13, even if an income tax is non-dischargeable, there are still two big benefits of filing bankruptcy. First, although the tax is non-dischargeable, you can get rid of penalties. Second, the filing of your Chapter 13 case stops the IRS from assessing future penalties and interest. This is important because paying the tax back without interest is a lot cheaper than paying it “outside” of bankruptcy with interest continuing to accrue.

What if the IRS has filed a tax lien?

A tax lien is where the IRS files a Notice of Lien in a local county clerk's office. Filing a tax lien does not make a dischargeable tax into a non-dischargeable tax, but filing a tax lien can substantially diminish the benefit. The reason is this. When a tax is dischargeable, by this we mean that it can be gotten rid of as a personal obligation of the taxpayer. What a tax lien does is put a lien on the things the taxpayer owns. More specifically, a tax lien is a lien against all personal property of the taxpayer, no matter where the property is located, and a lien against any and all real property that happens to be located in the county where the tax lien is filed. A lien encumbers the property which it affects, much like a mortgage encumbers your house.

For purposes of bankruptcy, if you want to keep the property encumbered by a tax lien, you have to pay the IRS at least the value of the property encumbered. For instance, if you own a home that is worth $100,000, with a mortgage payoff of $90,000 but you owe the IRS $30,000 in taxes for taxes old enough to be discharged. If the IRS files a lien for $30,000 in the county where this real property is located, the lien would eat up the $10,000 in the value of your home above what is owed on your mortgage. For purposes of Chapter 13, if you want to keep your home, you would have to figure in to your Chapter 13 plan payments sufficient to pay the full $10,000 to the IRS, plus interest. Assuming the lien does not encumber any other property, the other $20,000 would be discharged in the Chapter 13 case. The good news is that although the $10,000 needs to be paid to the IRS in Chapter 13, the IRS can be forced to take payments over the life of the plan, which can be up to 5 years, making the payment of this debt more affordable and preserving your right to keep your home.

For Chapter 7, using the same example, since liens generally “pass through bankruptcy” unaffected, the tax would be discharged, but the tax lien would remain a lien on your home after your bankruptcy case is done.

How Do You Find Out All The Information About My Taxes?

We make a special written request to the IRS for information. Getting information from the horse’s mouth is the only way we can properly represent you. As for information about taxes you may owe the state, we call the local bankruptcy department for the tax revenue office.

What about “income” taxes assessed by a State government?

With very few exceptions, the same rules that apply to the IRS apply to the State.

Disclaimer:

The discussion of taxes above has been simplified to promote understanding, and results will vary greatly depending upon your assets, debts, income, expenses, and the timing of your filing.

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