Can I Discharge My Income Tax Liability?

Debtors are often surprised to find out that personal income taxes can, under certain circumstances, be discharged in a chapter 7 bankruptcy. The parameters for discharging income-tax liability are spelled out in sections 507 and 523 of the bankruptcy code. Still, while personal income tax liability can be discharged - it can only be discharged if you can successfully navigate through the maze of requirements.

Secured Claim

Before applying all of the various tests associated with determining the dischargeability of personal income tax, one must first figure out if a federal tax lien has been filed by the Internal Revenue Service. Without getting into the gory details, a federal tax lien, even if the tax liability would otherwise be dischargeable, survives a bankruptcy filing to the extent that there is prepetition property that is available to secure the tax lien. In other words, a federal tax lien impairs or encumbers property that otherwise would have been exempt. Assuming that there is prepetition property, where a lien has attached, the IRS is considered a secured creditor. In that case, the debtor will need to open discussions with the IRS (negotiate to get the tax lien removed).

When a federal tax lien has not attached, however, an attorney works through the other requirements to see if the tax liability can be deemed unsecured and dischargeable.

The 3-year Rule

The tax must be one for which the tax return was not last due within three years of the bankruptcy filing. Thus, if a 2006 income tax return was last due on April 15, 2007, the three-year requirement would not be met until April 15, 2010. And if you get an extension? The three-year period begins after your last extension. Finally, the three-year period is tolled (paused) during the period in which a taxing authority is barred from collecting a debt during a previous bankruptcy.

The 240-day Rule

For income tax to be dischargeable, it must not have been assessed within 240 days of the bankruptcy filing. For federal taxes, the assessment date is the date the summary record is signed by a tax-assessment officer. The assessment date is typically around the same time that the tax return is filed (though not necessarily on the same date as the filing date).

The Late Tax Filing - 2-year Rule

If a return is filed late, it must not be filed within two years of the bankruptcy filing. The two-year period begins once the taxing authority receives the return -- not when the return is mailed. So, if the taxing authority received your late tax return on April 15, 2008, you cannot get a discharge of these debts until April 15, 2010 (assuming the other requirements have been met).

Unfiled, Fraudulent Returns, and Tax Evasion

The tax return must be filed by the taxpayer. A substitute return filed by a taxing authority, on behalf of a taxpayer, is not considered a valid return for this part of the test. The return must not be fraudulent. Finally, the debtor must not have attempted to evade the tax.

Example:

Jeff Johnson, a computer technician, earned $149,000 in 2005. His tax return for the 2005 tax year was due on April 15, 2006. Jeff did not withhold enough tax from his paycheck, so he owes federal taxes of $22,791 for the tax year of 2005.

Although Jeff has a tax obligation, he decides that it would be "smarter" to put off filing his taxes. Indeed, he cannot afford to pay $22,791 to the IRS. Jeff hopes that he'll be able to pay his taxes the following year (after he saves some money).

The following year, Jeff's computer work decreases. Instead of making more money, Jeff makes less. Jeff, once again, decides that he'll postpone his tax filing for the 2005 tax year.

Work doesn't get much better in 2007. Jeff, figuring that times won't get better any time soon, decides that it is time to file his 2005 taxes. He mails his 2005 tax return on March 14, 2008. The taxing authority receives his tax return on April 2, 2008. Jeff does not submit a check for $22,791 when he files his tax return. And Jeff does not arrange to make payments to the IRS.

Jeff, who has fallen on hard times (he lost his job late last year), shows up at the offices of an attorney on January 22, 2010, for a bankruptcy consultation. He has a bunch of credit card debt. He also has a tax obligation of $22,791 that he owes to the IRS. Jeff wants to know if he can discharge his 2005 tax obligation.

Armed with all of the facts, the bankruptcy attorney performs an analysis to figure out if Jeff can eliminate the tax obligation with a chapter 7 bankruptcy.

First, the attorney checks to see if a federal tax lien has attached to any property that can be used to secure the tax debt. In Jeff's case, no tax lien has attached. The attorney then moves on to see if Jeff meets all of the other requirements.

Was the tax return last due within the three years before Jeff files the bankruptcy? Because the tax return was last due on April 15, 2006, and because there were no other bankruptcies for Jeff (no tolling occurred), the attorney determines that the 3-year rule has been met.

Next, the attorney checks to see if the 240-day rule has been satisfied. For income tax to be dischargeable, it must not have been assessed within 240 days of the filing of the bankruptcy. Turns out that the tax was assessed on April 29, 2008. Therefore, the tax was not assessed within the 240 days before filing.

Because the taxes were filed late, though, the attorney must also be sure that the 2-year rule is met. If a return is filed late, it must not be received by the taxing authority within two years of the bankruptcy filing. In this case, Jeff's late tax return was received by the IRS on April 2, 2008 - within two years of today's date. Jeff fails this part of the test. If Jeff files a Ch. 7 bankruptcy petition today, his taxes for 2005 will not be dischargeable.

Assuming that there are no fraud or tax evasion issues, Jeff would not want to file his bankruptcy petition until at least April 2, 2010 (two years after the IRS received in his late 2005 income tax return). At that point, Jeff would meet all of the requirements necessary to get his income tax discharged.

Therefore, the attorney recommends that Jeff wait until sometime after April 2, 2010, to submit his bankruptcy petition, when his tax obligation of $22,791 can be discharged.