Throughout most of my 30+ year career, I have been interested in how a taxpayer can legally discharge federal and state income tax debts in a Chapter 7 Bankruptcy. You may have been told that income taxes cannot be discharged in bankruptcy. You may even have been told this by a lawyer. I can assure you that this statement is not correct. Chapter 7 Bankruptcy discharge of taxes is definitely an option for many people who owe delinquent income tax debts. In my career, I have represented hundreds of clients who have collectively discharged several million dollars in federal and state income tax. Click here to see an official IRS account transcript showing discharge of several thousand dollars in income tax.
Although there are many facts and circumstances that can complicate, delay or even deny an individual taxpayer’s bankruptcy discharge, thefive basic rules of discharging federal and state income tax in Chapter 7 Bankruptcy are pretty straightforward. However, you must bear in mind that these rules only apply to Chapter 7 discharge of state and federal income tax. Sales tax, employee withholding tax, real property tax, and other types of non-income taxes may not be dischargeable in a Chapter 7 Bankruptcy. Also, please be aware that a taxpayer can only discharge taxes in a Chapter 7 Bankruptcy if the taxpayer actually signed and filed his/her own return. Substitute for Return (SFR) assessments (See Myth No. 8) of income tax cannot be discharged in bankruptcy.
Now that the disclaimer is over, here are the five basic rules of income tax discharge in bankruptcy:
- The Three-Year Period. The original due date of the income tax return (plus extensions) must be at least 3 years before the bankruptcy petition filing date. That means that a 2011 income tax return filed without extension on or before April 15, 2012 can be discharged in a Chapter 7 bankruptcy filed on or after April 16, 2015. * I checked the April 2012 calendar. April 15, 2012 was a SUNDAY, so the income tax return was due on MONDAY, April 16, 2012. Just to be safe, I always add at least five days to the three-year period. * If the taxpayer filed for an automatic extension of time (IRS Form 4868) to file his/her 2012 return, the tax is dischargeable three years after the end of the extension period. ** I also checked the October 2012 calendar. October 15, 2012 was a SATURDAY, so the end of the extension period was (or will be) October 17, 2015 the following MONDAY. Now you know why I always add at least five days to the end of the three year period!
- **The Two-Year Period. If the income tax return is filed late, the return must have been filed at least two years before the bankruptcy petition filing date. CAUTION!! The federal courts have been chipping away at this rule. Three federal circuit courts (1st, 5th and 10th Circuits) have essentially read this rule out of existence. This new Circuit Court Judge-invented “interpretation” of the two-year rule holds that income tax on a late-filed return—whether it’s a day late or ten years late—cannot be discharged in a Chapter 7 Bankruptcy. Thankfully, IRS and many state tax agencies don’t follow this judge made rule. See my article on the 5thCircuit case here.
- The 240-Day Period. The income tax must have been assessed for at least 240 days before the bankruptcy petition filing date. “Assessment” occurs when the Treasury Secretary or an authorized delegate records “the liability of the taxpayer in the office of the Secretary in accordance with rules or regulations prescribed by the Secretary.” Tax on a return signed and filed by the taxpayer is typically assessed within four to twelve weeks after the return is filed.
- The No Fraud Rule. If the taxpayer’s return is “fraudulent”, the tax on the return will not be discharged in a Chapter 7 Bankruptcy. Whether the fraud is criminal (taxpayer is convicted of the crime of filing a fraudulent tax return) or civil (taxpayer is assessed a civil fraud penalty on his/her return), it makes no difference. If the tax shown due on the taxpayer’s income tax return is found to result from criminal or civil fraud, it cannot be discharged in a Chapter 7 Bankruptcy.
- Attempt to Evade or Defeat Rule. The taxpayer cannot have willfully attempted in any way to evade or defeat the assessment or collection of the tax. Like fraud, attempted tax evasion can be either civil or criminal. And like fraud, when the taxpayer willfully attempts to criminally or civilly evade his/her tax, the tax will not be discharged in a Chapter 7 Bankruptcy.
There are several exceptions to these five rules, both statutory and judge-made, but most taxpayers who meet the five basic rules above are eligible for Chapter 7 discharge. Call or email me and make an appointment. Let’s get together and see whether you qualify for Chapter 7 discharge of you income tax debts.
Call (918) 743-2000 or email firstname.lastname@example.org.