Tax Problems with the IRS or State Usually Are Not the Reason People File for Chapter 7 Bankruptcy
It seems to all come at once, doesn’t it? Generally when a person makes the decision to file for “bankruptcy protection,” tax debts are an afterthought. Other debts are usually the driving force behind a bankruptcy petition. But not carefully considering whether or not tax debts will be discharged through bankruptcy is a mistake, that – unfortunately – too many clients with tax problems make before they talk to an Attorney familiar with IRS procedures.
It usually goes something like this: a small business owner who has personally guaranteed loans for his or her business can no longer stand the constant calls from creditors. Business has fallen drastically, and it seems that there is no way for the client to dig himself out of the hole he is in. Since he is self-employed, and struggling to make ends meet, he probably hasn’t paid (and perhaps hasn’t even filed) his taxes for several years.
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I’ve seen court transcripts of judges and lawyers in family court all agreeing that income taxes are non-dischargeable. This is a common misconception within the legal community. I have also heard the same types of statements from actual bankruptcy attorneys or other tax professionals. The truth is that the most common type of tax debt – income tax liabilities – will almost always be dischargeable in a Chapter 7 bankruptcy at some point. The trick is knowing the rules and understanding what has gone on with a taxpayer’s account before filing the petition. (I have personally seen clients miss out on discharging a liability because they filed a petition two weeks too early.)
Tax debts usually are not the driving force between filing for a Chapter 7 Bankruptcy liquidation because the IRS, a government agency, is slow (at first) to collect the liabilities, and the IRS does not call business owners non-stop or send threatening letters as often as other creditors. Couple that with the assumption that too many clients and other attorneys make – that income taxes cannot be discharged in bankruptcy – and costly mistakes happen. So what are the rules for discharging tax debts in bankruptcy? Keep reading to find out.
Before continuing, please realize that there is only so much that can be covered in one blog post. You should consult with a legal professional regarding the dischargeability of your tax debts and not assume that your situation is covered below. Determining whether or not you can get rid of your tax debt in bankruptcy requires a close reading of both the Bankruptcy Code and the Federal (or State) Tax Code(s). Sometimes, whether or not a tax debt is dischargeable will depend on the case law specific to where you live.
Understanding the Difference Between dischargeable and non-dischargeable Tax Debts
The type of tax matters.
Generally, personal (individual) income taxes will be dischargeable in bankruptcy as long as the petitioner’s tax debts are old enough. This requires counting several different periods of time, and knowing when the clock on each period of time is “paused” because of various events that occur when trying to negotiate with the IRS about the debt. On the other hand, “Trust Fund” taxes (such as taxes assessed against an individual for failing to pay withholding/payroll taxes, certain excise taxes, or sales and use taxes) are generally not discharged in a Chapter 7 bankruptcy (but depending on how a sales tax liability was assessed – for example via an audit – it may be dischargable).
General Rules for Discharging Personal Income Tax in a Chapter 7 Bankruptcy
Keep in mind that a taxpayer must meet each rule below in order to get rid of a tax debt through bankruptcy. If one of the following requirements is not met, then a petitioner must wait to succeed in discharging the tax liability in bankruptcy. For each rule, the counting stops at the date you file a petition, not the date that the court orders the discharge.
- The return must have been due three years ago. The first rule is the simplest rule. In order for a tax debt to be dischargeable, three years must have passed from when the return was originally due. This is not an issue of when the tax return was filed but merely when it would have needed to be filed to avoid any late filing penalties. To explain further, if a tax return was due on April 15, 2012 – it cannot be discharged in bankruptcy until April 15, 2015. However, it an extension was filed, making the return due on October 15, 2012, then any petition filed prior to October 15, 2015 will not discharge the tax debt.
- The return must have been filed at least two years ago. If you missed the filing deadline, and filed after the due date (or extension date), then the return must have been filed two years or more prior to the filing of the petition.
- The tax debt must have been assessed for more than 240 days. The only way to know when a tax liability has been assessed is to take a look at your IRS Account Transcripts for the year in question. This date is usually fairly close to the date the return was filed, but it is almost never exactly the same date. Knowing the date of assessment is important. While this is the shortest period, it is possible that the IRS assessed more taxes as the result of an audit, or something else kept the IRS from properly processing the return. So even though this rule is the least likely to disqualify someone from getting rid of a tax liability, it is an important date to confirm. There are also several procedural events (such as filing for a CDP hearing, filing an Offer in Compromise, or requesting Innocent Spouse Relief) that will stop the clock for purposes of this rule, but not one of the other two rules. As a result, a detailed review of your IRS Account Transcripts is needed to make sure that this rule is met.
Knowing When to File a Chapter 7 Bankruptcy Petition
The rules above seem fairly straight-forward, but the problem is that it is easy for even an experienced Bankruptcy Attorney to overlook different administrative events within the IRS that will extend the period of time for one of the rules above. A Bankruptcy Attorney might not know, for example, that a Collections Due Process hearing stops the clock on the “3-year rule” and the “240-day rule” but that an “Equivalent Hearing” does not. They might not know the difference between the two types of hearings, or how to figure out what kind of hearing was held from an Account Transcript. There are also issues regarding prior bankruptcies, additional assessments, and assessments made as the result of the IRS filing a Substitute For Return or an Audit that might disqualify a tax debt from discharge. It is important to speak with an Attorney who is familiar with tax rules, reports, and regulations and the bankruptcy code when you are trying to deal with a tax debt in bankruptcy.
Using the Possibility of Bankruptcy Discharge to Negotiate a Better Settlement (Offer in Compromise) with he IRS
When considering an Offer in Compromise, the IRS is supposed to take into account whether or not the tax debt could be dischargeable in a Chapter 7 liquidation. When negotiating an Offer in Compromise with the IRS that includes older tax years, working with a representative that also has knowledge of the bankruptcy code as it relates to taxes, can result in a reduced Offer amount being accepted by the IRS. Most Tax Professionals and IRS personnel just ignore the potential for a bankruptcy discharge when negotiating the proper Offer amount, causing taxpayers to pay more than they should in order to reach a settlement with the IRS and avoid filing a bankruptcy petition.
Keep in mind that in a Chapter 7 bankruptcy, tax liens will generally survive a bankruptcy. This is because tax debts are secured for purposes of the bankruptcy code, and although personal liability has now been dealt with, the property of the taxpayer can still be used as a means to collect. For example, in a Chapter 7 bankruptcy where the petitioner is able to keep her home (up to $150,000 in Connecticut for certain filers), then the lien will remain on the home, and will need to be paid in order to sell the property. However, it is possible to make arguments that the lien should be released in certain circumstances. It is also possible to negotiate a lien release for a partial payment of the outstanding lien.
Filing for Bankruptcy might not be the best approach to dispose of tax debts in certain circumstances. Generally, the IRS only has 10 years to collect on a tax liability. If some tax years will not be discharged in a bankruptcy, filing for bankruptcy protect will extend the amount of time the IRS has to collect on those debts.