While a bankruptcy filing can have some long term negative impact on your credit-worthiness, sometimes the best option for dealing with the IRS or a state revenue agency is to remove the liability from their purview and place it in the hands of a bankruptcy court, especially if there are other creditors taking or threatening collection action on other debts. While our firm does not focus its practice in the area of bankruptcy, an understanding of the dischargeability of tax liabilities in bankruptcy is essential in properly advising clients as to their best options for resolving their liabilities.
Timing Considerations:
The most common form of bankruptcy through which to seek relief from federal or state income tax liabilities is Chapter 7 bankruptcy. In order for taxes to be dischargeable in bankruptcy, they generally must be “sufficiently ripe” for discharge. The rule for determining the ripeness of taxes for discharge in bankruptcy is commonly referred to as the “3 Year, 2 Year, 240 Day” or “3-2-240” Rule, which lays out 3 timing-related conditions that must all be satisfied for a tax liability to be dischargeable in Chapter 7 bankruptcy.
3 Years: In order to be dischargeable, the tax return underlying the liability must have been due, including extensions, at least 3 years prior to the date of the filing of the bankruptcy petition.
2 Years: In order to be dischargeable, the tax return underlying the liability must have been filed at least 2 years prior to the date of the filing of the bankruptcy petition.
240 Days: In order to be dischargeable, at least 240 days must have elapsed since the IRS or state revenue agency assessed the taxes (this period can be paused / extended by pending Offers in Compromise or previous bankruptcy stays in place during the 240 period).
Note that the 2 year rule requires that a return actually be filed in order for taxes to be eligible for discharge. Different federal courts of bankruptcy have interpreted what constitutes the filing of a valid return differently. Despite the fact that the bankruptcy code appears to explicitly provide for the discharge of late-filed returns (see the 2-year rule, above), some bankruptcy courts have said that returns that are filed late do not constitute valid returns and therefore a tax liability associated with a late filed return is ineligible for discharge. Fortunately, the IRS has taken a more lenient approach to contesting the dischargeability of late-filed returns in bankruptcy. Essentially, even if a return was filed late, the IRS will not contest the dischargeability of the underlying taxes so long as it meets the other ripeness requirements. However, one exception is that a return prepared by the IRS on behalf of a taxpayer under IRC §6020(b), commonly referred to as a “Substitute For Return,” is never dischargeable in Ch. 7 bankruptcy, even if an original return is later filed to replace the IRS-prepared SFR (though if an original return is filed that increases the assessed tax over that of the SFR, the portion of the tax assessed owing to the original return.
Even though the IRS takes a more lenient approach to contesting the dischargeability of late-filed returns, state revenue agencies are not required to take the same approach, so depending on which federal circuit your bankruptcy petition would fall under, the dischargeability of a late-filed state income tax return may vary.
Types of Tax Exempted from Discharge:
While income tax is generally dischargeable in Chapter 7 bankruptcy (provided it meets the ripeness rules), there are certain types of tax liabilities that are not dischargeable. For example, personal assessment of payroll tax liabilities (the “Trust Fund Recovery Penalty”) is not eligible for discharge in bankruptcy. FBAR penalties, orders of criminal restitution administered by the IRS, and state sales tax liabilities are also generally excluded from discharge in bankruptcy.
Effect of a Bankruptcy Discharge on IRS Liens:
A oft-overlooked aspect of discharging taxes in bankruptcy is the fact that even though the underlying tax liability may have been discharged, and the IRS may be prohibited from taking enforced collection action with respect to the liabilities subsequent to discharge, a valid Notice of Federal Tax Lien (NFTL) that was filed in advance of the bankruptcy petition will survive the bankruptcy discharge. This means that even if the underlying tax liability has discharged, the spectre of IRS collection could still hang over your head for a number of years after the bankruptcy discharge. Therefore, if a Notice of Federal Tax Lien has been filed and a taxpayer expects substantial real or personal property will survive the bankruptcy, real consideration should be paid to the possibility of liens surviving the discharge and encumbering that property in future, which could frustrate the taxpayer’s attempts to sell the property at a later date without having to turn any proceeds over to the IRS.
If you owe taxes and are considering bankruptcy as an option, please contact us so we can discuss your situation to assist you in determining whether bankruptcy is the best option for resolving your outstanding tax balances or whether working directly with the IRS or state revenue agency to resolve the tax liabilities administratively would be more beneficial.