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.
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.