DISCHARGING INCOME TAXES IN BANKRUPTCY

Many people have the mistaken belief that back due income taxes cannot be discharged in bankruptcy because a debt owed to the Federal and State government cannot be wiped out. That belief is wrong. Since 1966, bankruptcy law allows the discharge of debt to the IRS. However, there are rules that must be followed to discharge income taxes. This is where it can be tricky. Generally speaking, there are six rules that must be complied with to discharge income taxes: 

1. The three year rule. When was the income tax due and has three years lapsed? 
2. The two year rule. When was the tax return filed and has two years lapsed? 
3. The 240 day rule. Has the IRS assessed the tax due and has 240 days lapsed since the assessment? 
4. The fraudulent return rule. Was the tax return fraudulent? 
5. The willful tax evasion rule. Was there a willful attempt to evade or defeat the tax? 
6. The withholding tax rule. Was there a duty to withhold the tax? 

This is a general discussion. Be warned. Do not use this discussion to try to discharge your back due income taxes and if you fail to do so, use this article to blame me for your failure to do so. I had a potential client who owed half a million in back taxes. I told him to wait one more year before filing his Chapter 7 case. He decided to go to another lawyer who told him he could file his case immediately and did so. The IRS said that he filed his Chapter 7 case too early so the taxes were not discharged. 

Let’s look at rule 6. If you owe withholding taxes, you cannot discharge them. Before 2005, you can use a Chapter 13 discharge to get rid of withholding taxes owed. But the new bankruptcy law no longer allows this. If you owe withholding taxes and have no assets, try an offer in compromise instead. If the IRS is going after you for withholding taxes owed, you can file a Chapter 13 to pay what you owe to the IRS for withholding taxes over five years. For example, you owe $25,000 of withholding taxes, you can pay the IRS through Chapter 13 the amount of $416 monthly for 60 months without interest to get them off your back and buy you some peace and quiet. 

Let’s look at rule 1, the three year rule. This is Section 523(a)(1)(A) of the bankruptcy code that states priority tax claims under 507(a)(8) are not dischargeable for the period of their priority status. Subsection(i) provides that income tax remains a priority claim “…for which a return, if required is last due, including extensions, after three years before the date of filing of the (bankruptcy) petition…” In plain language the question to ask is was the return due more than three years before the bankruptcy filing? Let’s say you owe taxes of $10,000 for the year 2009. When was the return due? The return was due April 15, 2010. If you requested for an extension of time, then it was not due until the extended time elapsed. So, if you file your Chapter 7 today, February 28, 2013, you will not be able to discharge the $10,000 because you did not comply with the three year rule. You filed your Chapter 7 too early. If you did not file for an extension in 2010, then you should file your Chapter 7 case after April 15, 2013 when three years from April 15, 2010 has lapsed to comply with the three year rule. 

Another problem with the rule is that some things can “toll” or delay the counting of the three years. For instance, if the IRS could not collect the tax from you because you filed a Chapter 13 in a prior bankruptcy, the period of time you were in Chapter 13 is deducted from the three year computation. However, an offer in compromise does not “toll” the computation of time.