Tax Relief Through Bankruptcy
Many people believe that taxes are not dischargeable (i.e. not paid after an individual obtains a discharge in a bankruptcy case) in a bankruptcy case. This is not the case. Federal and state taxes may be discharged in a bankruptcy case for an individual only. Business entities are not eligible to discharge taxes in bankruptcy.
A tax must meet the following requirements to be dischargeable in an individual’s bankruptcy case for all bankruptcy chapters (7, 11, and 13):
- The tax to be discharged was last due and filed more than three years (this includes extensions; so the last due date is the filing of the return on an extension to file) before the individual files his bankruptcy petition;
- The tax return for the tax at issue must be filed more than two years before the individual files his bankruptcy petition (a return filed by the government for the taxpayer does not count for this item);
- The government must assess the tax against the individual more than 240 days before the individual files his bankruptcy petition. Assessment occurs when the government enters the tax as owed in its records.
- The tax at issue is not filed in a fraudulent tax return. Neither did the taxpayer attempt to evade the tax;
- The government no longer has the right to assess the tax when the individual files his bankruptcy petition; and
- The government has not taken action to obtain a security interest in the individual’s property when the individual files his bankruptcy petition. In bankruptcy terms, this means that the government has a general unsecured claim.
A taxpayer should request his transcript from the IRS and the state tax authority to determine whether the government has assessed the tax at issue or not.
A tax that is secured by a valid security interest of the government is not dischargeable. Further, a tax that does not meet one of the items one through six above is usually a priority tax claim in bankruptcy that has to be paid in full in the bankruptcy case. Otherwise, the government has a right to commence collection action against the taxpayer after the bankruptcy case is closed.
Tax penalties are dischargeable if the penalty is not to compensate the government for the unpaid tax, such as penalties for negligence, fraud, and accuracy. The trust fund recovery penalty imposed by IRC Section 6672 for unpaid payroll tax is not dischargeable. The general rule is that if the underlying tax is dischargeable, then the penalty is dischargeable. If a penalty meets the discharge rules above, then the penalty is usually dischargeable even if the tax is not.
Other benefits to file bankruptcy to resolve tax disputes are the bankruptcy judge will take into account the taxpayer’s ability to pay the tax; the impact of paying the tax on the taxpayer’s financial situation, and to help the debtor get a fresh start financially. These concerns are ignored by other courts that hear tax litigation.