There is a common misconception that income taxes are never dischargeable in bankruptcy. In fact, you can discharge some back federal, state, and local income taxes in Chapter 7, Chapter 13, and Chapter 11 bankruptcy. Moreover, the penalties and interest attached to these taxes are dischargeable as well. Determining which back taxes are dischargeable can be a complex process. Nonetheless, it is possible to discharge significant income tax debt in bankruptcy, if your tax debt fits within certain rules.
THE 3 YEARS, 2 YEARS, AND 240 DAY RULES
The Bankruptcy Code sets out specific time periods that determine if you can discharge your taxes, commonly called the 3-year, 2-year, and 240-day rules (the “3-2-240 rules”). Under these rules, you can discharge income taxes that came due three years before you file for bankruptcy, as long as it has been at least two years since you filed the tax forms and 240 days since the taxes were assessed. There are some exceptions, and these rules do not apply to other types of taxes, such as property taxes.
To discharge back income taxes, be aware that you must meet the requirements of all three rules.
1. The 3-Year Rule. This rule states that to discharge your back income taxes, they must become due at least three years before you file for bankruptcy. Bankruptcy Code §507(a)(8)(A)(i). Typically, your federal and most state income taxes become due on or around April 15th of each year. In most cases, it is merely a matter of adding three years to this due date to determine the earliest date you can file for bankruptcy and still discharge your taxes.
Example: Joe’s 2008 federal income taxes are due on April 15, 2009. If Joe owes taxes for that year and wants to discharge them, the earliest he can file for bankruptcy is April 15, 2012 (April 15, 2009, plus three years).
However, if you get an extension of time to file, the three-year period runs from the date that the taxes are due under the extension.
Example: Joe files for and receives an extension of time in which to file his 2008 taxes to October 15, 2009. The tax due date is now October 15, 2009, rather than the original due date of April 15th, 2009. If Joe wishes to discharge those taxes, he must wait to file for bankruptcy until October 15, 2012.
2. The 2-Year Rule. Under the 2-year rule, your income tax returns must have been filed at least two years before you file your bankruptcy petition. This requirement allows you to discharge your taxes even if you file your tax forms late, as long as you file the forms at least two years before filing for bankruptcy. §523(a)(1)(b)(ii).
Example: Jill’s 2008 income taxes are due on April 15, 2009. She does not get an extension, and she does not get around to filing her tax forms until June 1, 2010. If Jill wants to discharge her 2008 taxes, she cannot file for bankruptcy until June 1, 2012 (two years from the date she filed her tax return and more than three years from the date her taxes were due).
Quick Note: Despite the clear wording of the two-year rule, there are limitations and potential limitations on the ability of a debtor to discharge taxes arising from late-filed forms. See “Important Note on Late-Filed Returns” below for details.
3. The 240-Day Rule. Taxes must have been assessed by the taxing agency at least 240 days before you file for bankruptcy under this rule or not assessed at all. As a practical matter, the original date of assessment is typically on or near the date you file your income tax form (assuming the IRS or other taxing agency agrees on the amount of taxes owed).
Example: Joe files his 2008 tax return on April 15, 2010. The IRS assessed the taxes the same day. Joe met the requirements of the 3-2-240 rules on April 15, 2013. (This example is a bit simplified. You should always check the actual assessment date and not assume it is the same as the filing date.)
Amended or corrected returns and audits. If you file a corrected return, or if a change results from an IRS audit, the assessment date may be substantially later. §507 (a)(8)(A)(ii). For that reason, if you are in a dispute with the IRS regarding how much you owe and plan to file for bankruptcy, you should tell your bankruptcy lawyer about the dispute.
Example: Joe filed his original return on April 15, 2010. The taxes, along with some penalties and interest, were assessed on December 31, 2010. Joe then files a corrected return on June 1, 2011, showing that he owes additional taxes. Based on this amended return, the IRS assessed new taxes, penalties, and interest on January 1, 2013. Joe must now wait to file for bankruptcy until August 28, 2013 (January 1, 2013, plus 240 days) to discharge the entire tax debt. If Joe files for bankruptcy before this new 240 day period is complete, the taxes assessed in 2010 would still be dischargeable, but the new taxes, penalties, and interest would not be dischargeable.
Example: Jill files her 2008 tax return on time on April 15, 2009, and assesses her taxes shortly after that. However, the IRS audits Jill’s taxes and finds that Jill made a mistake. Unbeknownst to Jill, she owes a few hundred dollars more than the amount shown on her original tax form. The IRS assesses the additional taxes along with some penalties and interest on March 1, 2012. If Jill wants to discharge the newly assessed taxes, penalties, and interest), she will have to wait until October 27, 2012, to file for bankruptcy (240 days from the IRS’s new assessment).
Tolling. Some actions can add additional time to some or all of the 3-2-240 time requirements, including (a) making an offer in compromise, (b) having filed for bankruptcy previously, or (3) obtaining a taxpayer assistance order. §507(a)(8)(A)(i). The time periods under the 3-2-240 rules are tolled (suspended) while any of these events are pending. However, entering into a payment arrangement with the IRS or another taxing agency does not toll the time periods under the 3-2-240 rules.
Quick Note: If you are in a payment arrangement with the IRS, you should stop payments upon filing for bankruptcy, unless instructed by your attorney otherwise. The IRS cannot take any collection action against you while you are protected by the automatic stay of the bankruptcy. If the payment is deducted automatically, be sure to take the necessary steps to stop it.
ORDERING TAX TRANSCRIPTS
Unfortunately, finding the due date, filing date, and assessment date is not as simple as looking at your last form. To determine if your taxes are dischargeable, you should obtain an “account transcript” (sometimes called a “literal transcript”) from the IRS for each year for which you owe taxes. The account transcript will show the due date, filing date, and assessment date, which are crucial in determining whether the taxes fit within the 3-2-240 rules.
How to OrderTax Transcripts: To order a tax return transcript, see http://www.irs.gov/Individuals/Order-a-Transcript. You can order the transcript online, by phone at 1-800-908-9946, or by using IRS Form 4506T. The request will take up to two weeks to process. Note that an “account transcript” is not the same as a “tax return transcript.” A “tax return transcript” will not have all the information you need.
TYPES OF TAX DEBT: SECURED, PRIORITY, AND GENERAL UNSECURED
Before dealing with interest and penalties, it is important to understand the differences in the way the bankruptcy code classifies tax debt.
General Unsecured Debt. Unsecured income tax debt is debt that is not priority debt and is not secured by a lien. Other common types of unsecured debts include unsecured credit cards, bank loans, medical debts, personal loans, etc. Although most general unsecured income tax debt is dischargeable under the 3-2-240 rules, the taxing agency will sometimes allege that debt is nondischargeable for another reason, such as a late-filed return. (See Limitations on Discharge below.)
Example: George owes the IRS $12,000 in back taxes for 2010. He filed his forms on time. George files for bankruptcy in 2016. The entire $12,000 is a general unsecured debt and dischargeable, assuming no exceptions apply.
Priority Tax Debt. Income tax debt classified as priority debt is unsecured tax debt that does not fall under the 3-2-240 rules. Other priority debts include certain government charges, child support, maintenance, etc. Priority debts are non-dischargeable in bankruptcy. However, penalties and some interest on priority tax debt may be dischargeable in Chapter 13. (See the Penalties and Interest section below.
Example: Lauren files for bankruptcy in 2016. She owes taxes for 2015 and 2014. Because these taxes do not fall under the 3-1-240 rule, they are priority tax debts and are not dischargeable in bankruptcy. Lauren may want to consider if she should wait to file.
Secured Tax Debt. If the income taxes are secured by a lien issued by the IRS or another taxing agency, the debt should be listed as secured. However, the lien is limited to the value of the creditor’s property. The remaining unsecured portion of the debt becomes either general unsecured debt or priority debt, depending on whether it falls under the 3-2-240 rules.
Example. The IRS files a tax lien against Mike’s personal and real property of $200,000 for back taxes. Mike has only $30,000 in equity in his home after subtracting the mortgage, and his personal property is worth only $20,000. Mike files for bankruptcy. The total value of Mike’s real and personal property is $50,000. The secured portion of this debt is $50,000. The remainder of $150,000 becomes a general unsecured debt or a priority debt, depending on whether they fall under the 3-2-240 rules.
Quick Note: If you have secured tax debts, it is crucial to be as accurate as possible when listing your real and personal property in bankruptcy schedule A/B. Because tax liens are limited to the value of the property in bankruptcy, placing excessive value on your property could prevent you from discharging taxes that would be otherwise dischargeable. If necessary, work with your attorney to obtain valuations or comps for more valuable personal property and consider having a realtor provide a valuation for real property.
INTEREST AND PENALTIES
For the most part, interest and penalties are treated the same in Chapter 7 and 13. However, there are some differences, with regard to priority debts, which we will discuss.
Discharging penalties on back taxes. Tax penalties more than three years old are dischargeable in both Chapter 7 and Chapter 13 bankruptcy unless the IRS or other taxing agency has secured the debt by filing a tax lien. (See tax lien section below for limitations on tax liens.)
Discharging interest on back taxes. In both Chapter 7 and Chapter 13, if the taxes are dischargeable, the interest is dischargeable as well.
Penalties and interest on priority tax debts in Chapter 7. In Chapter 7, penalties and interest on priority tax debts are not dischargeable.
Penalties and interest on priority tax debts in Chapter 13. All penalties and post-petition interest are discharged in Chapter 13 if the debtor completes the Chapter 13 plan. Therefore, if you have significant penalties on priority tax debt, filing under Chapter 13 may be a better option, particularly if you cannot wait for the taxes to qualify under the 3-2-240 rules.
Penalties and interest on secured tax debts. Interest and penalties on secured tax debt are not dischargeable up to the value of the security interest in the debtor’s property. (See secured tax debts above.)
Post-petition interest on secured debts. Taxing agencies may be entitled to post-petition interest on secured tax debt, which the debtor must pay as part of the plan in a Chapter 13 case.
Income taxes that you incur personally as a result of operating a business are dischargeable in bankruptcy under the 3-2-240 rules. However, different rules apply to other business-related taxes:
Payroll Trust Fund Taxes. Trust fund taxes are not dischargeable in bankruptcy. Trust fund taxes include payroll taxes that employer withholds from an employee’s pay on behalf of the government. If you fail to withhold required taxes or withhold the taxes from an employee’s check but fail to pay the withheld funds to the taxing authority, the taxes are not dischargeable.
Employer’s Portion of the Payroll Tax. The employer’s part of the payroll tax (the tax paid directly by the employer for Social Security and Medicare) is dischargeable in bankruptcy under rules similar to the 3-2-240 rules. The debtor must file for bankruptcy a minimum of three years from the date that the IRS 941 form was due and two years from the date the debtor filed the tax forms.
Sales Tax. Like other trust fund taxes, sales taxes are not dischargeable in bankruptcy in Pennsylvania.
TAX LIENS UNDER THE 3-2-24 RULES
Discharging income taxes in bankruptcy does not automatically remove a tax lien. You can certainly file for bankruptcy with a tax lien, and the underlying debt will be discharged (assuming you meet the requirements of the 3-2-240 rules). However, any lien against the property you acquired before filing for bankruptcy would still stand. Fortunately, there are options for dealing with tax liens after bankruptcy.
Voluntary Release of a Post-Discharge Tax Lien. In Chapter 7 cases, the IRS will often release liens after a bankruptcy discharge when the taxes are dischargeable, and there is little property to which the lien can attach. However, the debtor may need to request the release of the lien.
Settlement of a Tax Lien. The IRS usually will not release a lien after discharge when the debtor has substantial nonexempt property holdings. However, it is sometimes possible to negotiate a settlement of the lien in such cases for less than the full amount.
Payment of a Tax Lien in Chapter 13. In Chapter 13 cases, the debtor must pay the tax lien through the Chapter 13 plan as a secured debt. (The IRS will generally reduce the lien to the value of the debtor’s property when it files its proof of claim.) Once the lien is paid in bankruptcy and the debtor receives a discharge, the IRS or other taxing agency will remove the lien. Again, you may have to contact the agency, if it fails to act within a few months of the discharge.
Expiration of Federal Tax Liens. Most IRS tax liens expire when the 10-year period of collectability ends. IRC §6322. Therefore, sometimes it is possible to wait out a tax lien, although it would be unwise to do so without consulting an attorney. (See also Statutes of Limitations section below.)
ENFORCING THE DISCHARGE
If the taxing agency (whether the IRS, the state, or local government) tries to collect on tax debts discharged in bankruptcy or refuses to remove a tax lien that should be lifted, speak to your attorney. It may be necessary to file an action for violation of the discharge. Taxing authorities and other government entities are not exempt from laws protecting discharged debtors.
LIMITATIONS ON DISCHARGE UNDER THE 3-2-240 RULES
There are circumstances when taxes are not dischargeable, even though the debtor meets all of the requirements of 3-2-240 rules. The most important exceptions include tax evasion, fraud, the filing of substitute forms by the IRS, and, possibly, forms filed late without an extension.
Tax Evasion and Fraud. If a taxpayer willfully evades taxes or commits tax fraud, the taxes involved are not dischargeable. §523(a)(1)(C). However, this rule applies only in the case of deliberate tax evasion, not an honest mistake.
Substitute Forms. Substitute forms, which may be filed by the IRS when a taxpayer has not filed a form, can affect your ability to discharge taxes in bankruptcy. Whether the taxes assessed on substitute forms are dischargeable depends largely on whether the-the IRS filed the forms with or without the taxpayer’s permission.
Consensual Substitute Forms. A substitute form filed by the IRS with the taxpayer’s consent and signature is a properly filed tax form, and any taxes arising from it are dischargeable under the 3-2-240 rules.
Nonconsensual Substitute Forms. If the IRS files a substitute tax return on your behalf without your agreement, the taxes may not be dischargeable, even if they otherwise meet the 3-2-240 rules. The IRS has taken the position that taxes assessed on a nonconsensual substitute form are not dischargeable, and several court rulings have agreed. Moreover, some courts have held that none of the taxes on tax forms filed after the IRS has filed a nonconsensual substitute form are dischargeable in bankruptcy. In other words, the taxpayer cannot make the tax debts dischargeable by filing a tax form after the IRS filed the substitute form.
Quick Note: Do not accept a substitute form as accurate. Just because the IRS has filed a substitute form does not mean you should not file your own form for the same tax year. Very often, substitute forms vastly overestimate taxes. In fact, I have seen substitute forms that were incorrect by tens of thousands of dollars. Therefore, if the IRS files a substitute form, you should have it reviewed by a CPA, and in most cases file your own form. You will likely save money.
IMPORTANT NOTE ON LATE-FILED RETURNS
Unfortunately, a few courts, including a federal appeals court have held that a tax return filed even a day late is not a tax return for the purpose of the statute allowing discharge of tax debts in bankruptcy. In other words, if your forms were filed late without an extension in any given tax year, you cannot discharge the taxes for that year.
To be sure, both the IRS’s and the courts’ interpretations of the statute are tortured and run counter to the purpose of the Bankruptcy Code. Hopefully, the U.S. Supreme Court will clarify this issue shortly. However, until this issue is decided by the Third U.S. Circuit Court of Appeals (which covers Pennsylvania) or by the Supreme Court, I advise clients that debts arising from late-filed forms that were not subject to an extension may not be dischargeable. In the meantime, if you have unfiled forms, you should get them filed as soon as possible. If you know you will be filing late, get an extension.
Quick Note. There is no upside to not filing your tax forms or filing them late. In my Philadelphia bankruptcy practice, I sometimes see clients whose taxes would have been dischargeable, if only they had filed their tax forms or filed them on time. Many people do not file on time because they know they will owe taxes and cannot pay them. However, the monetary penalties for not filing your tax forms are much worse than the penalties for paying your taxes late. Moreover, not filing leads to audits, and in extreme cases, criminal prosecution. Failure to file can result in loss of remedies, including the ability to discharge taxes in bankruptcy. Again, if you are going to be filing your tax returns late, get an extension. If you have been putting off filing your taxes, now might be a good time to sit down with your tax professional and get it done.
DEALING WITH INCOME TAX DEBT WITHOUT FILING FOR BANKRUPTCY
Statutes of Limitations on Collection of Income Taxes. Statutes of limitations on both the assessment and collection of federal, state, and local income taxes can greatly reduce the liability of a taxpayer for back taxes. (For more on statutes of limitations in general, see my post on the Pennsylvania Statute of Limitations on debt.) Statutes of limitations bar the taxing authority from either collecting old taxes or assessing new taxes after a certain amount of time has passed.
Federal Statute of Limitations On Collection of Taxes. The Statute of Limitations on the collection of federal income taxes is ten years from the date the IRS assessed the taxes. After this period passes, the IRS cannot collect the remaining tax debt in most cases. IRC §6502. (To find the assessment dates, get an “account transcript” as described above.) As noted above, tax liens usually expire with the ten-year statute of limitations on collection.
There is no statute of limitations if the IRS has filed suit against the taxpayer and reduced the lien to judgment. Fortunately, the IRS rarely seeks a judgment. Filing an offer in compromise, filing an appeal, signing an IRS Form 900 waiver (a voluntary extension), and some other actions can toll the Statute of Limitations and allow the IRS more time to collect.
Filing an offer in compromise, filing an appeal, signing an IRS Form 900 waiver (a voluntary extension), and some other actions can toll the Statute of Limitations and allow the IRS more time to collect.
Federal Statute of Limitations on Assessment of Taxes. There is a three-year limitation on the assessment of new taxes and penalties by the IRS running from the date that the return was filed. IRC § 6665(a). This limitation extends to six years when the taxpayer has failed to declare a significant amount of income. IRC § 6501(e).
Pennsylvania Statute of Limitations on Collection of Taxes. Pennsylvania sets no limit on the collectability of unpaid state income taxes. Put another way, state income tax debt is forever in Pennsylvania unless settled or discharged in bankruptcy.
Pennsylvania Statute of Limitations on Assessment of Taxes. Pennsylvania has a three-year limitation on the assessment of new taxes that runs from the date of the original assessment, 061 PA Code § 119.14. This period could be extended to six years if the taxpayer underreported income by at least 25 percent. 061 PA Code 119.15. But that limitation does not apply in cases involving fraud, tax evasion, or failure to file forms. 061 PA Code § 119.16. In other words, the state can add to an income tax assessment for only three years (sometimes six) but has no time limit in which to collect taxes that are already owed.
Quick Note: Bankruptcy filings will suspend statutes of limitations on taxes for the duration of bankruptcy plus six months. Although this is not always an issue, it is something your attorney will need to consider, particularly if you are close to the end of the statutory collection period.
Offers in Compromise. An offer in compromise is an agreement between the debtor and the IRS to settle a tax debt for less than the full amount due. This type of settlement can result in a waiver of interest and fees and even a portion of the underlying taxes. The IRS accepts very few offers in compromise. Nonetheless, in some cases, an offer in compromise may be the best solution. The offer-in-compromise process is complex and can be quite time-consuming. Taxpayers seeking an offer in compromise should speak to a CPA or a tax attorney.
Payment Arrangements. The IRS will usually accept a payment arrangement (“installment agreement”) for back taxes unless the debtor has repeatedly failed to pay under previous agreements. Most such arrangements require a minimum monthly payment of two percent of the balance. An installment agreement will not waive penalties or prevent interest from accruing. If the debtor can only make minimum payments, such arrangements can take a very long time to complete.
Most state and local taxing agencies, including the Pennsylvania Department of Revenue and Philadelphia Revenue Department, offer payment arrangements. However, if significant taxes are at stake, it is wise to speak to a CPA or a tax attorney before entering into any such agreement.
The rules governing the discharge of tax debts in bankruptcy proceedings can be quite complex. But that should not discourage you from considering the possibility. An experienced bankruptcy attorney can help determine if you can discharge your income tax liability and whether other options may be available in your case.