Can you Discharge Income Taxes in Chapter 7 Bankruptcy?

Can You Discharge Income Taxes in Chapter 7 Bankruptcy?

The short answer is maybe! Prospective bankruptcy clients may owe income taxes to either the Internal Revenue Service and/or the State when filing for Chapter 7 bankruptcy. Most taxes debts will be excepted from the bankruptcy discharge, meaning these debts will survive the bankruptcy and still be due, but there are limited instances where the tax liability can be discharged in Chapter 7 bankruptcy. It is important to discuss these issues with a San Diego Bankruptcy Attorney thoroughly before filing a Chapter 7 bankruptcy, as often the tax year in question might be discharged if the taxpayer waits an additional time frame before filing Chapter 7 bankruptcy. This article discusses the general requirements in order to successfully discharge income tax liabilities under Chapter 7 of the Bankruptcy code.

The “3 Year” Rule

First, the tax debt being discharged must be for a tax year that pre-dates the bankruptcy filing by 3 years, including any extensions that may have been filed for which the return then became due under. For instance, if a taxpayer owed the IRS for income taxes for the 2016 tax year, the tax liability will generally be due by April 15th the following year, or April 15, 2017. However, what if the taxpayer filed for an extension making his return now due on October 15, 2017? October 15, 2017 starts the “3-year” rule, and to discharge the 2016 tax year’s liability, the first rule requires that the taxpayer wait 3 years, or until after October 15, 2020, to file the Chapter 7 bankruptcy case.

The “2 Year” Rule

Next, the tax return for the tax liability in question must have been filed at least 2 years before the bankruptcy case was filed. This is known as the “2 year” rule. Keeping with our example above, where the taxpayer requested an extension but fails to actually file his return until April 15, 2018, we would need to count 2 full years from when the return was actually filed to determine whether the “2 year rule” has been satisfied. In this case 2 years would be April 16, 2020, meaning the bankruptcy will need to be filed on or after April 16, 2020, in order to satisfy the “2-year” rule. Its important to note the return must be actually filed by the taxpayer. Often the IRS will file what’s called a “Substitute for Return”, or SFR, if the taxpayer fails to timely file a return. The IRS’s “SFR” return will be based off either historical returns filed by the taxpayer and/or information that was provided to the IRS from employers, banks, and/or other payers. The SFR, though acts as a “return”, causing the IRS to collect on taxes owed, does not suffice as a “return” under the requirement that the tax return be filed at least 2 years before the Chapter 7 bankruptcy case was filed.

240 Day Assessment Period

Assuming the tax liability meets both the “3 year” rule and the “2 year” rule above, the next consideration in determining whether the tax can be discharge under Chapter 7 bankruptcy has to do with tax assessments and audits. A tax assessment is a determination of how much the taxpayer owes the taxing authority, usually in writing, sent to the taxpayer shortly after the tax return was filed. The assessment can confirm in writing what the taxpayer’s record reflects or it could reflect additional sums after a return has been audited. Taxing authorities are generally allowed 240 days to collect on their tax assessment notices before the tax liability in question can be discharged in Chapter 7 bankruptcy. It is important to review for any assessments made in the immediate 240 days of the bankruptcy filing, as if an assessment was made during this time period by the taxing authority the taxpayer will need to wait and file once the 240 day period runs.

No Fraud or Willful Evasion

Lastly, in order to discharge an income tax liability under Chapter 7 of the bankruptcy code, the tax return must not be fraudulent, and the taxpayer must not be guilty of tax evasion. In most instances a taxpayer will know whether they have been found guilty of tax evasion, as such will usually have resulted after a hearing and adjudication by the taxing authority. As to whether a return is fraudulent, you can’t expect to file bankruptcy and discharge taxes you owe because you claimed your dog as a dependent and the IRS called you out on it. This is a situation that most taxpayers should know whether it applies to them before going into the analysis of determining whether the tax will be discharged in under Chapter 7 bankruptcy.

Discuss the Tax Debt with Your Attorney

It is important to consider the ramifications a Chapter 7 bankruptcy filing will have when it comes to income tax debts. Filing the case too soon will prevent such debts from being discharged in the bankruptcy and thereby limit the ability of the debtor to seek a fresh start. Likewise, if the taxpayer has failed to file the returns, it may be advantages to file the returns to start both the 3-year rule and 2-year rule, if the debtor can otherwise wait the requisite time period before filing the bankruptcy. Often the IRS or State will agree to a payment plan once the return has been filed, which my assist the taxpayer in waiting the appropriate time necessary to otherwise discharge the taxes under Chapter 7 bankruptcy.

Written by Shawn Doan-