The broad rule in bankruptcy is that tax debts are not dischargeable in Chapter 7, Chapter 11, or Chapter 13 bankruptcy proceedings and that these debts have the eighth priority for payment of claims. There are, however, a number of exceptions to this broad rule under which certain income tax debts may be dischargeable by an individual taxpayer in a Chapter 7 bankruptcy proceeding. If the obligation is discharged, then creditors may not attempt to collect the debt.
I. The Three-Year Rule
If the due date for the tax return, including any extensions, is greater than three years from the date of the filing of the bankruptcy petition, then the debt is dischargeable (11 U.S.C. §507(a)(8)(A)(ii)). Under the “three-year rule,” the due date for the tax return, including any extensions, is the starting point and the date of the filing of the bankruptcy petition is the end point. The three year period is extended if the taxpayer has filed a prior bankruptcy petition, filed a case in Tax Court, or extended the statutory period for assessment. Under such circumstances, the three year period is extended as long as the proceeding is pending under bankruptcy or nonbankruptcy law, plus an additional 90 days.
II. The 240-Day Rule
For the tax debt to be dischargeable, the assessment date for the taxes must be greater than 240 days prior to the date the bankruptcy petition is filed (11 U.S.C. §507(a)(8)(A)(ii)(iii)). The 240 day period is extended by an additional 30 days if the taxpayer has an offer in compromise pending. The 240 day period is also extended as long as any prior bankruptcy proceeding is pending plus an additional 90 days. If the taxes are assessed after the petition for bankruptcy is filed, then the debt is not dischargeable even if the debt would be otherwise dischargeable under the “three-year rule.”
III. Withheld or Collected Taxes
If the debtor is liable, in whatever capacity, for a tax required to be withheld or collected, then that tax debt is not dischargeable (11 U.S.C. §507(a)(8)(C)). This exception from discharge includes income taxes that an employer must withhold from employee pay, the employer’s share of social security taxes, and sales taxes paid by the debtor’s customers that the debtor is required to turn over to the government. These responsibilities might also be imputed to a responsible officer of the corporation when such a person filed under Chapter 11.
IV. Tax Penalties
Tax penalties that are imposed in compensation for an actual loss are not dischargeable debts (11 U.S.C. §507(a)(8)(G)). An important caveat around is that tax penalties that are punitive, instead of compensatory, are dischargeable. Another caveat is that tax penalties are dischargeable if the tax to which it relates is dischargeable or if the transaction that gave rise to the penalty occurred greater than three years before the bankruptcy petition is filed.
V. Failure to File Return
The tax debt will not be dischargeable based on the fact that the taxpayer failed to file a tax return (11 U.S.C. §523(a)(1)(B)(i)). Further, the IRS has an unlimited opportunity to learn of the tax deficiency, even after the bankruptcy proceeding terminates. If the return was filed on behalf of the taxpayer pursuant to IRC Section 6020, then that does not constitute filing a return and the debt will not be discharged. A debt may be dischargeable, however, if the taxpayer filed some sort of return at some appropriate time disclosing the taxpayer’s income.
VI. Two-Year Rule
If the tax return was filed more than two years prior to the bankruptcy petition, then the debt is dischargeable (11 U.S.C. §523(a)(1)(B)(ii)).
VII. Fraud and Willful Evasion
If the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat the tax, then the debt is not dischargeable (11 U.S.C. §523(a)(1)(C)). The mere failure to pay taxes, however, does not fall within the scope of this rule, because the taxpayer must have willfully evaded the payment of taxes. This rule has no time limit under which the courts must determine that fraud or willful evasion occurred.
All interest accumulated prior to the bankruptcy petition is not dischargeable, because it is considered a part of the claim against the debtor. Interest accumulated after the bankruptcy petition might be dischargeable if the tax obligation is discharged.
CIRCULAR 230 NOTICE: To comply with U.S. Treasury Department and IRS Regulations, we are required to advise you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this transmittal is not intended or written to be used, and cannot be used, by any person for the purpose of (i) avoiding penalties under the U.S. Internal Revenue Code; or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this email or its attachments.