Filing Bankruptcy to Discharge Income Tax Debt

Written by Summerville Bankruptcy Lawyer, Russell A. DeMott

You may be able to discharge taxes in bankruptcy, but not always.   To understand the benefits of filing bankruptcy to deal with tax debts, you need to understand some basic bankruptcy principles.

We’ve all heard radio and TV advertisements that claim to wipe out income tax debt.   But it’s not as easy as the commercials claim.   It is, however, possible to discharge your federal or state income tax debt by filing bankruptcy.

The 3/2/240 Rule

The 3/2/240 rules says that for income taxes to be discharged in bankruptcy: (1) the taxes must have been due more than three years prior to filing bankruptcy, (2) you must have filed your return more than two years prior to filing bankruptcy, and (3) the taxes must have been assessed at least 240 days prior to filing bankruptcy.   Note that all these elements must be satisfied.

For instance, if you owe taxes for one of the last three years (including extensions), then they can’t be discharged in bankruptcy.   You will still owe them after a Chapter 7 bankruptcy case; alternatively, you will also be required to pay them in full in a Chapter 13 repayment plan.   (Taxes you can’t discharge in Chapter 7 are called “priority debts” and must be paid in full in a Chapter 13 bankruptcy.)

Let’s look at an example of the three-year rule.   If a clients comes to me for help with 2006 income taxes, I can now discharge those because they were due (assuming they were filed on time) on April 15, 2007.   Because more than three years have gone by, those taxes are dischargeable in bankruptcy.   However, let’s change the facts a bit.   What if the client got an extension?   That would mean the tax return was not due to be filed until October 15, 2006.   As of the date of this post (May, 2010) three years have not gone by, so if the client got an extension, those taxes would not be dischargeable.   One other thing: sometimes taxes are not due until April 17 because the 15th is on a Saturday.   In that case, you’d need to wait until after April 18 three years after those taxes were due and filed.

And if the taxes were due more than three years ago–say even six years ago–if at least two years hasn’t gone by since you filed your return, those taxes can’t be discharged.

There is also another important requirement: There can be no fraud or willful evasion. If you filed a fraudulent tax return or attempted to evade paying taxes, then bankruptcy won’t help.   You will be required to pay the tax debt.   More importantly, tax fraud is a felony and can result in prison time, so don’t take the “easy way out” by engaging in fraud or tax evasion.

Interest and Penalties on Federal Income Tax Debt

The rule is simple and logical: If the underlying income tax debt is dischargeable, then the penalties and interest will also be dischargeable.   Likewise, if the debt is not dischargeable, the penalties and interest won’t be, either. However, in Chapter 13 penalties can be discharged–paid as general unsecured debt, rather than priority debt, which must be paid in full.

And then there are tax liens

You should know that even if your tax debts are dischargeable, any tax liens will remain in force: bankruptcy does NOT eliminate previously recorded tax liens.   As bankruptcy lawyers say, “liens survive bankruptcy.”   So if the IRS recorded a tax lien prior to your bankruptcy filing, then you will have to pay the tax secured by the lien if you want to keep your property.   Dealing with tax liens is one good reason to file a Chapter 13 bankruptcy.   In Chapter 13, the value of the property securing the tax debt must be determined and that amount paid in your Chapter 13 payment plan.   However, as long as the value of the property is paid, and all other terms of your Chapter 13 plan are met, the IRS (or state) can’t take collection action against you.

This is Just a Quick Overview

This post only deals with income taxes.   Other rules apply to payroll taxes, property taxes, and sales taxes.   If you have tax debt, be sure to contact a bankruptcy lawyer for more information.   You may also need more specialized help from a tax lawyer or accountant.

Finally, check out this memorandum from the IRS Office of Chief Counsel, which is an excellent (an fairly in-depth) recourse for tax issues in bankruptcy.

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Comments

  1. Jeff Kelly says:

    Russ,

    I often meet with small business self employed clients who do not understand the nature of their tax liability. They come to me thinking they owe income taxes but upon further investigation we discover that its nondischargeable payroll taxes.

  2. Russ DeMott says:

    Thanks for your comment, Jeff. It is challenging pinning down tax liability. With payroll taxes, you further have to divide the liability by the employee share and the employer share. The emploYER share can be discharged under the 3/2/240 day rule. This underscores the need for clients to provide their bankruptcy lawyers with accurate information as well as the need to taylor the attorney fee to the unique facts of each case.

  3. Sam Turco says:

    Russ,

    The IRS has recently been sending collection notices to debtors for interest that has accrued on priorty tax debts that were paid during the Chapter 13 case. The IRS says the tax was discharged/paid, but the accrued interest remains nondischargeable. Are you seing these post-discharge collection notices?

    Sam Turco

  4. Russell DeMott says:

    I have not had that problem. Keep me posted.

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