Income Tax Debt in Bankruptcy

Wasson and ThornhillTax Debts

tax debt bankruptcy timing

Getting rid of tax debt in bankruptcy is all about timing

Bankruptcy writes off income tax debt if they meet certain conditions. These conditions are relatively, but not completely, straightforward.

Income taxes owed to the IRS and state tax agencies can be legally written off (“discharged”) if they meet certain conditions, conditions which are sometimes not all that hard to meet. In this blog post we briefly describe those conditions, touch on some practical challenges in meeting these conditions, and then summarize how Chapter 7 and Chapter 13 handle these “dischargeable” tax debts.   

The Two Main Conditions for Discharging Income Tax Debt in Bankruptcy: It’s all about the timing

The conditions for discharging an income tax in most situations are quite straightforward. Usually it just takes filing your tax returns and waiting out a certain amount of time.

The two main conditions for discharging taxes in bankruptcy:

1. more than 3 years must have passed between the due date for the tax return of the tax at issue and the filing date of the bankruptcy case; and

2. more than 2 years must have passed between the date that pertinent tax return was actually submitted to the IRS/state and the filing date of the bankruptcy case.

If Enough Time Has Not Yet Passed

These conditions are easy enough if enough time has already passed to meet them when you’re ready to file bankruptcy. And if either the 2-year or 3-year condition have not yet been met, it may be worth waiting until they have. But often waiting is not easy because of financial pressure from the tax agencies or other creditors, or both. Then, whether to wait to file in order to discharge your tax debt in bankruptcy requires a judgment call unique to each person’s entire circumstances, a judgment call that you honestly should only make with the guidance of a competent bankruptcy attorney.

Challenges with the 3-Year Condition

There are two important practicalities to keep in mind for meeting the condition of filing your bankruptcy case more than 3 years after the pertinent tax return’s due date:

1) That tax return due date includes any extensions for filing the tax returns that you asked for and were granted. So in these situations the 3-year period doesn’t start to run until the extended tax return due date. For example, if you had asked for and got an extension for the 2009 tax return from April 15, 2010 to October 15, 2010, then the condition would only be met if the bankruptcy was filed beyond 3 years later, that is, after October 15, 2013.

2) If your case is getting filed as soon as possible because of pressure from creditors, you and your attorney need to be very precise about the actual date the pertinent tax return was due. For example, when April 15 (or October 15) falls on a weekend or holiday, it’s not legally due until the next business day. That difference of only one or two days can make the difference between a tax debt being completely discharged and being fully owed.

Challenges with the 2-Year Condition

There are two important practicalities to keep in mind for meeting the condition of filing your bankruptcy case more than 2 years after the pertinent tax return’s submittal date:

1) To meet the 2-year condition, you of course need to know when the tax agency in fact received the return. Unless you already have absolute proof of that date, it’s wise to get that directly from the IRS/state to make sure.

2) Sometimes, if you don’t file a tax return the IRS/state may at some point prepare a “substitute for return.” That does not start this two-year period running. Only your own submitted tax return counts for starting the 2-year period running.

Two Other Rare Conditions for Discharge

Most of the time, the above two conditions are all that must be met to discharge an income tax debt in bankruptcy. But there are two others which, although seldom apply, are worth mentioning:

1) More than 240 days must have passed since the income tax at issue was “assessed.” Tax agencies “assess” your taxes when they make a formal determination about your tax liability. Practically speaking, the 240-day period is easily met when, as usual, assessment happens within a few weeks after you submit the tax return.  In that situation the 240-day period runs long before either of the above 2-year and 3-year conditions are met, making this 240-day period irrelevant. This condition only comes into play when a tax assessment gets delayed, such as in situations where the amount of the tax is in dispute because of a tax audit or litigation.

2) Filing a fraudulent tax return or intentionally evading the tax makes that tax not dischargeable. The other 240-day, 2-year, and 3-year conditions become irrelevant. This tax-fraud condition is very uncommon, arising only if you were significantly dishonest on your tax return. Very likely, if you believe you completed your tax return honestly, have not been accused by the IRS/state of tax fraud or tax evasion, and are not being audited, this condition won’t be a problem.

Chapter 7

If you owe an income tax that meets the above conditions of discharge, when you file a Chapter 7 “straight bankruptcy” case that income tax debt would be discharged within a matter of about 3 months. This means that the IRS/state would never be able to take any action whatsoever to collect that tax.

In the somewhat unusual event that some of your property or possessions are not “exempt”—unprotected—so that your Chapter 7 trustee could take and sell them, your tax debt would receive a prorated share of the proceeds of such a sale, just like any other “general unsecured” debt.

Chapter 13

An income tax that meets the conditions for discharge is treated in a Chapter 13 “adjustment of debts” just like any other “general unsecured” debt. Under Chapter 13 Plans such creditors are paid a percentage of the amount owed, ranging all the way from 0% to 100%, based on what you can afford and what other more important debts you owe. At the end of the 3-to-5-year Chapter 13 case, the portion not paid is discharged.

Paying possibly something on such tax debts in a Chapter 13 case instead of nothing in a Chapter 7 case, and taking 3 to 5 years instead of about 3 months to discharge the tax, these make Chapter 7 sound much more sensible if you owe income taxes that meet the discharge conditions. And if that’s all the taxes you owe, Chapter 7 may indeed be the better option. But often people who owe older taxes that meet these conditions also owe more recent taxes that don’t, which often are handled better under Chapter 13.

How bankruptcy handles taxes which don’t meet the conditions of discharge will be the topic of our next blog post.