Discharging Taxes

Often, income taxes can be discharged (wiped out) in bankruptcy, but in order for the taxes to be wiped out, they have to pass tests which are set out in the Bankruptcy Code.

The general idea is that recent taxes cannot be wiped out.  The taxing agency (for example, the IRS or the California Franchise Tax Board [FTB]) is given a certain amount of time in which to collect the taxes before the taxes can be wiped out in a bankruptcy.

There are three different time periods which have to be tested to see whether taxes are old enough to discharge in a bankruptcy.

  1. The taxes must have come due three years or more before the bankruptcy was filed,
  2. The tax return must have been filed two years or more before the bankruptcy was filed, and
  3. The taxes must have been “assessed” (officially logged-in by the taxing agency) more than 240 days before the bankruptcy was filed.

The first test is the “3-year rule.”  The 3-year rule usually means that for normal income taxes (which come due on April 15 of the year after the tax year), any bankruptcy filed after April 15 of the fourth year after the tax year can be wiped out in a bankruptcy, but this is not always the case.  For example, if the person gets an extension of the date to file a tax return to August 15 or October 15, that tax debt will not pass the 3-year test until after August 15 or October 15 of the fourth year after the tax year.

In practice, the 3-year rule is even more complicated.  If April 15 falls on a weekend, the IRS usually sets the due date as the next business day (presumably Monday).  However (to make things more complicated) in 2012, April 15 was a Sunday, but the IRS set the due date for 2011 tax returns as Tuesday, instead of Monday. Therefore, in order to pass the 3-year rule regarding 2011 federal income taxes, a bankruptcy case filed in 2015 must not be filed before Friday, April 17 (based on current law, which could change by then).  It would be unfortunate for a person who owes taxes for 2012 (and for their attorneys) files a bankruptcy on April 16, 2015, thinking that they will be wiping out their 2012 income tax debt, only to find out that they have been April-fooled by the IRS and that they filed their bankruptcy case a day too soon.

The second test is the “2-year rule.”  The 2-year rule usually means that in order for taxes to be wiped out, two years must pass between the date a tax return is filed with the taxing agency and the date the bankruptcy case is filed.  If tax returns are filed on time, the two years of the 2-year rule also pass during the three years of the 3-year rule.

Late-filed returns and unfiled returns add more complications. If tax returns are filed late, then the later they are filed, the more important the 2-year rule becomes.  For example, when someone does not file tax returns for a few years and then files several returns at about the same time, then for the older tax years the 3-year rule may be satisfied, but if a bankruptcy is filed before the two-year anniversary of the tax return filing, it will not wipe out those taxes.  Late-filed returns may also make a tax nondischargeable and also not a priority claim.  In addition, sometimes when tax returns are not filed by a taxpayer, the IRS will file a tax return for the taxpayer.  This is called a “SFR,” which stands for Service-Filed Return, or Substitute For Return, depending on who you ask.  SFRs do not start the 2-year rule time period running, so in order to be able to wipe out these taxes in a bankruptcy, the taxpayer must file something that is acceptable as a tax return.  Exactly what that “something” is has been the subject of many tax court cases. Most courts accept the filing of a regular 1040 return.  But, a few courts have decided that it is impossible for anything which is filed late to qualify as a tax return.  Most bankruptcy and tax experts believe that these decisions are simply wrong, and luckily, none of these bad decisions affect cases in our area.

The third test is the “240-day rule.”  The 240-day rule usually means that in order for taxes to be wiped out, they must have been assessed more than 240 days before a bankruptcy case was filed.

The time-periods for these three tests are “tolled” or delayed if certain things happen.  The time periods for all three tests are “tolled” if the person is in a bankruptcy during the required time period. The calculation of these tolling periods is somewhat complicated.  In addition, the 240-day rule is also tolled by Offers in Compromise which are made by the taxpayer to the IRS or other taxing agency.  In fact, when there is an Offer in Compromise which overlaps the 240-day period following the assessment of taxes, the 240-day period is extended by the entire time of the Offer in Compromise overlap plus another 30 days.

When taxes can’t be wiped out, a Chapter 13 can still help.  Even when taxes fail one or more of the three tests and can’t be discharged, there are two ways in which a Chapter 13 payment plan can provide relief.

A Chapter 13 can help by providing a way to pay the taxes over up to five years, stopping penalties and most interest.  In addition, the IRS and FTB are prevented from harassing and collecting the taxes while the taxes are being paid through the Chapter 13.

 

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.