June 25, 2018

Discharging Income Taxes in Bankruptcy

I regularly get questions about the dischargeability of taxes in a personal bankruptcy.  This area of the law is not simple, as there are numerous exceptions for every rule.  Florida Attorney Larry Heinkel wrote a very comprehensive discussion comparing bankruptcy to the IRS “offer in compromise” program – Larry’s article reflects Florida law to some extent, but the general principles apply.

The Bankruptcy Code only allows for discharge of income tax debts.  If you own or owned a small business and you owe 941 (trust fund) taxes, those taxes are not dischargeable.

If you do owe federal or state income taxes they may be dischargeable (wiped out) in a Chapter 7 if:

  • the taxes came due more than three (3) years prior to your bankruptcy filing

Example 1: Tom filed his 2000 tax returns on March 14, 2001, and he owes $10,000 for tax year 2000.  The $10,000 becomes dischargeable on April 16, 2004, which is three years from the date that the tax year 2000 taxes came due.

Example 2: Mary got an extension on April 14, 1999 and her 1998 income tax return due date became October 15, 1999.  Mary filed her 1998 return on October 10, 1999, and she owes $7,500.  The $7,500 becomes dischargeable in bankruptcy on October 16, 2002.

  • if the original return was filed late, the late filed return was filed more than 2 years prior to the bankruptcy filing

Example: Sam filed his 1999 tax return on September 23, 2003 and he owes $5,000.  The $5,000 becomes dischargeable on September 24, 2005.

  • the tax must have been assessed more than 240 days prior to filing bankruptcy
  • the tax return must not be fraudulent
  • the taxpayer must not be engaged in an effort to evade taxes

Here are some other things to keep in the back of your mind:

No missing tax returns. You need to be up to date with your tax filings.   Many bankruptcy trustees will not hold your 341 meeting of creditors hearing if you have missing tax returns from the last four years.  I suspect that Chapter 7 and Chapter 13 trustees in various districts throughout the country have their own standards about how many years of tax returns they will require, but the point here is that bankruptcy trustees want to know if you have non-dischargeable tax liability because it affects the administration of your case.

Tax Liens = trouble. Tax liens can also create issues, especially in Chapter 13 cases.  If the IRS has filed a tax lien, there is no process in a bankruptcy where that lien can be eliminated.  In Chapter 7, I have taken the position that the federal tax lien attaches to any equity in property you have as of the date of filing.  Subsequent appreciation or increase in equity does not accrue to the benefit of the taxing authorities.

So, if you have a situation where you have income tax debt subject to a tax lien and the tax debt itself is “stale” and dischargeable, then, in theory at least, you can go to the IRS or state tax authority following discharge and negotiate a settlement of the tax lien that arises from newly discharged tax debt.

I can tell you from personal experience that the IRS has little interest in formalizing this type of agreement and it can be very frustrating and time consuming to obtain documentation regarding any settlement of a tax lien.  Instead, the IRS will advise you to check your tax transcript periodically to confirm that the lien has been adjusted, and they will advise you that there will not be any attempts at collection on the tax lien “at this time.”  Not a very reassuring position, to be sure.

State tax departments of revenue (i.e., the Georgia Department of Revenue) has been reluctant to accept the notion that the discharge of stale tax debt should have any bearing on the validity or collectability of its tax lien.  In other words, Georgia takes the position that its tax lien remains in full force regardless of any discharge of underlying tax debt.

Tax liens and Chapter 13. Tax liens can also be a major problem in Chapter 13 cases.  Since Chapter 13 is a payment plan, all listed creditors receive a “proof of claim” form whereby they file their claims with the trustee.  Claims are paid based on the provisions of the debtor’s plan and according to priorities set out in bankruptcy law.

Secured debts are generally paid in full.  A tax lien, by definition, is a secured debt.  So, a valid tax lien on an otherwise stale income tax debt will be filed by the IRS or state tax authority as a secured claim.   The existence of a $15,000, $20,000 or larger secured debt can make a big difference in your plan payment and in some cases it can create a jurisdictional problem by putting your secured claim total over the jurisdictional limit for Chapter 13 (currently $1,010,650, but subject to upward adjustment in the future).

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