It is a common misperception that taxes can never be discharged in bankruptcy. I was always taught that taxes will follow me to my grave. The truth is, however, under some circumstances, some taxes may be discharged. This may relieve individuals and families of what may feel like an insurmountable debt burden. Using bankruptcy strategically in this way may give people even more of a fresh start than they had already counted on. Today, I wanted to talk about taxes and how they fit into bankruptcy. Specifically, I wanted to discuss some of the criteria that needs to be satisfied before the taxes may be discharged.
There is a series of conditions that must be met before your IRS taxes may be discharged.
- The taxes have to be “income taxes.” Taxes for things other than income, such as payroll, withholding, and other “trust-type” taxes (which business owners frequently have to deal with) can never be discharged in bankruptcy. Make sure that the taxes you are seeking to discharge are the 1040 taxes.
- You must not have committed fraud or willful evasion. You did not file a fraudulent tax return or otherwise willfully attempt to evade paying taxes. Debts incurred through fraud or illegal activity are not dischargeable.
- You have to pass the three-year rule. To be dischargeable, the tax must be for a tax year for which the tax return was originally due at least three years before you file for bankruptcy. For example, in 2020, taxes filed for tax years 2016 and earlier may be eligible for discharge if all other conditions are present. For example:
On July 15, 2020, taxes for the 2019 tax year were due. 2018 taxes were due last year, and 2017 taxes were due the year before that—three tax years. So, if you are filing your bankruptcy after July 15, 2020, debts from tax years 2016 and earlier may be dischargeable. However, if you filed before July 15, 2020, debts from tax years 2015 and earlier may be dischargeable, but the 2016 tax year may not be.
- You have to pass the two-year rule. You actually filed the tax return at least two years before filing the bankruptcy. Having the IRS file a substitute return for you (which may happen if you don’t file your taxes on time) doesn’t count unless you agreed to the return and signed the substitute return. One strange quirk in the 2-year rule: The Court of Appeals that has jurisdiction over Texas has ruled that if a person files his taxes late, the 2-year rule may not get satisfied. The take home message on this is that you should always file your tax returns on time, whether you can afford to pay the tax or not. Otherwise you risk the tax debt becoming permanently nondischargeable.
- One more time period. You have to pass the 240-day rule. The IRS typically assesses the income tax debt at least once for each tax year. Any assessment of the income tax debt by the IRS must have occurred at least 240 days before you file your bankruptcy petition. If you get a tax return transcript (available for download at irs.gov), the date of the assessment is on that document.
- The taxing authority must not have filed a lien against your property. Once a tax lien has been filed, the tax debt becomes secured up to the value of the property that the lien is attached to. Before you file your bankruptcy, be sure to check whether there are any tax liens filed.
If you cannot discharge your tax debts outright in a Chapter 7 bankruptcy, Chapter 13 may be a better alternative because it gives you time to pay the tax debt and gives priority to the IRS so that the Trustee can pay the tax debt before spending the money on credit card debt.