Are Income Taxes Dischargeable in Bankruptcy? It Depends.

It may not be common knowledge but income taxes can be discharged in bankruptcy if certain rules are met.

Not all debts are dischargeable, it de-pends on the chapter under which the case was filed and the nature of the debt. Legal counsel must be retained to assist with the filing of the bankruptcy and the appropriate action to be taken by the tax-payer.

Payroll trust fund taxes, however, are not dischargeable in bankruptcy. Trust fund taxes include payroll taxes that the employer withholds from an employee’s pay and fails to pay the withheld taxes to the appropriate taxing agency. The individual business owner may be assessed the liability for trust fund taxes if the business entity is unable or fails to pay the withheld funds to the appropriate taxing agency. (In a separate discussion, an offer in compromise may be submitted to reduce the liability for the payroll trust fund taxes.)

The Bankruptcy Code sets out specific time periods that determine if the tax-payer can include the tax liability in the bankruptcy, commonly referred to as the “3-2-240 rules.” The taxpayer must meet the requirements of all three rules in order to discharge back income taxes.

To begin with, in order to be discharge-able taxes must meet the three-year rule. That is, they may not be discharged prior to three years after the due date of a return including extensions. Typically, federal and most state income taxes become due on or around April 15th of each year. In most cases, it is simply a matter of adding three years to this due date to determine the earliest date you can file for bankruptcy and still discharge your taxes.

EXAMPLE: Joe’s 2008 federal income taxes are due on April 15, 2009. If Joe owes taxes for that year and wants to discharge them, the earliest he can file for bankruptcy is April 15, 2012 (April 15, 2009, plus three years).

However, if you get an extension of time to file, the three-year period runs from the date that the taxes are due under the extension.

Example: Joe files for and receives an ex-tension of time in which to file his 2008 taxes to October 15, 2009. The tax due date is now October 15, 2009, rather than the original due date of April 15th, 2009. If Joe wishes to discharge those taxes, he must wait to file for bankruptcy until October 15, 2012.

The second rule relating to discharging income taxes in bankruptcy is the 2-year rule. This rule in particular applies to late filed tax returns. If a tax return is filed more than 12 months after its due date, two years after the date the return was filed must pass before the tax may be discharged. The IRS claims that in certain cases, if they assess liability prior to the taxpayer filing a return, it should not be dischargeable in bankruptcy.

EXAMPLE: Jill’s 2008 income taxes are due on April 15, 2009. She does not get an extension, and she does not get around to filing her tax forms until June 1, 2010. If Jill wants to discharge her 2008 taxes, she cannot file for bankruptcy until June 1, 2012 (two years from the date she filed her tax return and more than three years from the date her taxes were due).

And finally, in order to be discharged in bankruptcy, taxes must also meet the 240-day rule. If the taxes sought to be discharged stem from an audited or amended return, 240 days must pass after the date of assessment prior to dis-charging the tax.

EXAMPLE: Craig files his 2008 tax return on April 15, 2010. The IRS assessed the taxes the same day. Craig met the requirements of the 3-2-240 rules on April 15, 2013. (This example is a bit simplified. You should always check the actual assessment date and not assume it is the same as the filing date.)

AMENDED OR CORRECTED RETURNS AND AUDITS. If the taxpayer files a corrected return, or if a change results from an IRS audit, the assessment date may be substantially later. §507 (a)(8)(A)(ii). For that reason, if the taxpayer is in a dispute with the IRS regarding how much is owed and plans to file for bankruptcy, the bankruptcy lawyer should be aware of the dispute.

EXAMPLE: Joe files his original return on April 15, 2010. The taxes, along with some penalties and interest, are assessed on December 31, 2010. Joe then files a corrected return on June 1, 2011, showing that he owes additional taxes. Based on this amended return, the IRS assessed new taxes, penalties, and interest on January 1, 2013. Joe must now wait to file for bankruptcy until August 28, 2013 (January 1, 2013, plus 240 days) to dis-charge the entire tax debt. If Joe files for bankruptcy before this new 240 day period are complete, the taxes assessed in 2010 would still be dischargeable, but the new taxes, penalties, and interest would not be dischargeable.

EXAMPLE: Jill files her 2008 tax return on time on April 15, 2009, and her taxes are assessed shortly after that. However, the IRS audits Jill’s taxes and finds that Jill made a mistake. Unbeknownst to Jill, she owes a few hundred dollars more than the amount shown on her original tax form. The IRS assesses the additional taxes along with some penalties and interest on March 1, 2012. If Jill wants to discharge the newly assessed taxes, penalties, and interest), she will have to wait until October 27, 2012, to file for bankruptcy (240 days from the IRS’s new assessment).

Smith v. IRS, No. 14-15857 (9th Cir. 2016…

In 2002 a U.S. taxpayer (Smith) failed to file his 2001 tax return by the prescribed due date. In fact, it was not until 7 years following that the taxpayer filed a delinquent return. At the time the return was filed, approximately 3 years had already passed since the IRS assessed liability against the taxpayer for the 2001 tax year in the form of a Substitute for Return (“SFR”). Subsequent to filing the late return and allowing the two-year period to pass, the taxpayer petitioned for the 2001 taxes to be discharged. The bankruptcy court initially granted the taxpayers request.

Unfortunately for the taxpayer however, the IRS contested the ruling by appealing the case to the U.S. District Court. The U.S. District Court found in favor of the IRS. Subsequently, the taxpayer appealed the case to the U.S. Court of Appeals. In their decision, the U.S. Court of Appeals sided with the U.S. District Court and determined that the late filed return was not discharge-able under 11 U.S.C. 523(a)(1)(B)(i). They claimed that a return filed 7 years after its due date and 3 years after an IRS assessment was not an “honest and reasonable” attempt to comply with the tax code.

The US Court of Appeals made their decision based upon what they determined was and was not an “honest and reasonable” attempt to comply with the tax code. There is some subjectivity in the court’s decision. The take-away here is that even if your clients cannot afford to pay their taxes when they are due, they should still file a tax return and the return should be filed timely. No one enjoys facing the possibility of needing to file for bankruptcy, but should it become necessary, it is nice to know that one’s taxes will be wiped away with all of their other dischargeable debt.

By filing one’s returns timely, the ability to discharge the tax becomes more black and white. If you have a client who cannot afford to pay their tax liability, be sure to let them know that not filing their returns limits their options in dealing with their tax issues in the future.