Discharging Taxes in Bankruptcy

So you didn’t think you could bankrupt taxes? Filing a petition under Chapter 7 can often erase your tax debt. Income taxes can be discharged in a Chapter 7 bankruptcy, but only if all of the following tax code rules are met:

  1. The tax return on which the tax debt arises must have been due at least three years before you file for bankruptcy.
  2. The tax return must have been filed at least two years ago for a tax year at least three years ago-this usually means April 15 of the year the return was due. If an extension was filed, then it means August 15 or October 15 of that year, or beyond to the actual filing date. If the 15 th falls on a Saturday or Sunday, the return wasn’t due until the following Monday. The tax return must also have been filed at least two years before the bankruptcy. (If the IRS files a substitute for a return it doesn’t count.)
  3. Taxes other than income, such as payroll taxes, a 100% penalty, Trust Fund Recovery penalty, fraud penalties, or several other unusual types of taxes are by law excepted from bankruptcy discharge.
  4. The tax must have been assessed over 240 days ago.

The tax claim must be unsecured or there must be no equity in the property to take (this is explained later).

If the tax return was fraudulent, or shows a willful evasion of payment, these taxes will not be discharged.

Any limitation on the time allowed to the IRS to collect, such as non-filing of the return or an offer in compromise or bankruptcy, “tolls” or extends the “3-Year Rule” past April 15 th of the third year after the return was due. Other events can delay the bankruptcy filing date to discharge taxes, including prior bankruptcies. The time rules (3-Year, 2-Year and 240-Day) are all delayed by the period in the prior bankruptcy proceeding, plus an additional 6 months. If you file an Offer in Compromise, the 240-Day period is extended by the period it is under IRS consideration, plus 30 days.

The idea behind a Chapter 7 is that you turn over all your assets to the Court, which in turn pays your creditors from that property. In most cases, there is no property to turn over after you are allowed to keep the minimum allowed to “start over” (your exemptions).

In a Chapter 7, the immediate impact of filing bankruptcy is that all collection efforts are stopped by a Federal Court Order called a stay. The IRS is included in this stay. The only way a collector can overcome the automatic stay while your bankruptcy case is still open is to apply to the Bankruptcy Court.

Judges will rarely lift a stay for the IRS, unless the IRS can prove some kind of fraud is being perpetrated by the bankrupt taxpayer. Unfortunately, the statute of limitations for collections runs only while a person is not in bankruptcy. If the bankruptcy is not finished (discharged), the tax bill will not age for purposes of the statutes of limitations. If you go into bankruptcy and emerge from the process still owing the IRS, it gives the IRS extra time to collect the balance. This often happens if the taxpayer has some, but not all, of their taxes erased in a Chapter 7.

As a result, many taxpayers end up filing a “Chapter 20”, wherein they first file a Chapter 7 to eliminate what tax can be eliminated and then file a Chapter 13 to deal with what is left. The IRS can have a total of ten years to collect taxes, penalties, and interest. Once a bankruptcy case is over, the IRS gets whatever time remained on the original ten years, plus the time the bankruptcy case was pending-plus an additional six months to collect the remaining debt (if any). Chapter 7 cases will add about 4 months to this.

The Tax Rules about Chapter 13

Taxes do not necessarily have to be paid in full, but this is up to the discretion of the bankruptcy judge. The debts and the plan to repay them can be “crammed down”. In order to be discounted, the taxes must be:
a) income taxes; with
b) returns due more than three years before filing
c) assessed by the IRS at least 240 days ago.

To be crammed down, the IRS must not have recorded a valid lien or there is no property for that lien to attach.

If a tax return was due less than three years ago, or the taxes were assessed less than 240 days ago, or the taxes are not income taxes (such as for payroll), they are “priority” taxes.

Priority taxes must be paid off in full through the plan. However, a Chapter 13 stops interest and penalties the moment it is filed. Under IRS Installment Agreements (IA), interest and penalties continue to run. So, paying $1,000 per month under an IA for a $60,000 tax bill leaves a balance of at least $30,000 after five years. The same payment in a Chapter 13 plan pays off the tax debt in full! Chapter 13 forces the repayment plan on the IRS. The IRS cannot get anything more than the bankruptcy judge approves. The IRS cannot restart collection activities or seizures of property or wages as long as a Chapter 13 plan is underway. This is a powerful way to get around an unreasonable Revenue Officer who won’t agree to a fair IA. In most Chapter 13 plans, the monthly amount paid to the IRS is far less than IA proposals that the IRS rejects.

Tax interest penalties may be greatly reduced by the Court. Even fraud penalties, never dischargeable in Chapter 7, can be reduced in a Chapter 13.

Unfiled income taxes may be paid as a fraction on the dollar. Though actual filing of tax returns is a requirement to discharge taxes in a Chapter 7, there is no “2- Year Rule” in Chapter 13.

Tax Liens and the liability for the taxes are extinguished when a Chapter 13 is completed.

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