Resolving Tax Debt in Bankruptcy

There is a common belief that IRS individual income tax debt cannot ever be discharged in a bankruptcy case. This is not true. IRS taxes can be discharged in a chapter 7 or chapter 13 case under certain circumstances. However, there are strict requirements to discharge tax debt in a bankruptcy case and the rules are unforgiving.

First, more than three years must have passed since the tax debt was due, including extensions. For instance, if the tax debt was for 2015, technically the tax debt was not due until April of 2016 (it would be important to look at the actual calendar and IRS filing due dates since if the 15th falls on the weekend, and the 2015 tax return was not due until April 18, 2016). Add three years. The earliest that the bankruptcy filing should occur to be able to discharge the tax debt would be April 19 of 2019.

Second, the tax return must have been actually filed by the taxpayer at least two years before the bankruptcy petition. A substitute return prepared by the IRS would not meet this requirement.

Third, the IRS assessment must have occurred at least 240 before the bankruptcy filing.

In addition to satisfying the above three requirements, the bankruptcy discharge of the taxes can be denied due to fraud or tax evasion.

There are traps so it is important to follow these rules and to look for events that trigger a “tolling” (extension) event of time. The taxpayer’s actions may cause the three-year period to be extended. For instance, a collection due process hearing will extend the time. An “Offer in Compromise” that has been received by the IRS will extend the 240-day assessment period required to qualify for a discharge. The period is extended while it is being processed, plus an additional 30 days is added. Filing an extension to file the tax return will also extend the three-year rule from April 15 to the extended filing date in October of that year, plus three years. A prior bankruptcy filing will also “toll” the time while the taxpayer was in the bankruptcy case, plus 90 days after the taxpayer is no longer in bankruptcy. It is important to have an experienced bankruptcy attorney review the IRS transcript of account for each tax year in question prior to the bankruptcy filing to determine whether the taxes can be discharged in bankruptcy case. The account transcript will include various three-digit codes which must be reviewed carefully.

In a chapter 13 case, the priority tax debt (taxes from the past three years) will be paid as part of the bankruptcy plan. Older income tax debts, so long as they meet the above requirements, can also be discharged in a chapter 13 case.

The issue of the extent of federal tax liens is complicated and beyond the scope of this brief summary. In a chapter 13 case, it is necessary to determine whether the IRS has a secured claim by the recording of a Notice of Federal Tax Lien. The homestead exemption will not defeat the federal tax lien, and in a chapter 13 case the plan must provide for the “secured” portion of the IRS debt. For instance, if the home has a value of $300,000, the mortgage balance is $250,000 and the IRS has a recorded tax lien of $100,000, the plan must provide $50,000 as a secured claim to the IRS. The remaining IRS tax debt would be unsecured.

Due to the strict requirements and potential traps for the unwary, I highly recommend that anyone with tax debt consult with an experienced bankruptcy attorney.