Eliminating Personal Income Taxes Through Bankruptcy

Many Americans have faced the grim reality of owing unpaid income taxes to the Internal Revenue Service (IRS).  For some, these taxes are large and one unpaid year can lead to another until the taxpayer owes several years of income taxes.  The taxpayer can be stupefied by both the amount and the possibility that the tax bills may never go away. But….is that true? Not exactly. A taxpayer may use the bankruptcy process to eliminate certain kinds of income debts, either partially, or in full.

Dischargeable Taxes in Bankruptcy

The Bankruptcy Code does not have a list of what taxes are dischargeable; it only says what is not dischargeable.  First, figure out what is not dischargeable – meaning you cannot eliminate them through bankruptcy. Anything outside of what is not dischargeable is– dischargeable.  If the pre-petition tax is dischargeable, it follows that any related penalties and interest are also dischargeable.

Examples of non-dischargeable taxes:

  1. Income taxes falling inside the time window are not dischargeable.
  2. Claims for taxes and duties “of the kind and for the periods specified in section 507(a)(3) or 507(a)(8)”, whether or not a claim for such tax  was filed or allowed  and for which a return was not filed, or for which a return was filed both late and within 2 years prior to the petition date are not dischargeable.
  3. Fraudulent or false return. If the Debtor filed a fraudulent return or “willfully” tried to evade or defeat the taxes, those taxes are not dischargeable.
  4. Late filed returns.

The Third Circuit, in In re Giacchi 856 F.3d 244 (3rd Cir. 2017) held that the late filed 1040 did not constitute filed returns that could otherwise be dischargeable if they otherwise complied with Section 507. The Third Circuit focused on the language of § 523(a)(1)(B), which provides in relevant part, “any . . . debt for a tax . . . with respect to which a return, or equivalent report or notice, if required, . . . was not filed or given.” If the return was not filed or given then the corresponding tax is not dischargeable regardless of age. Caution though, a late filed return can be considered timely filed but you must satisfy the IRS four-part test.

When are Pre-Petition Tax Obligations Dischargeable?

The short answer:

            When they do not fall under the kind and periods test of Sections 507(a)(3) and (a)(8).

The long answer:

   Remember the 3-Year Rule, the 2-Year Rule, and the 240-Day Rule, and remember that you have to comply with them all.

Taxes are dischargeable if all of the following rules are met:

  • The 3-Year Rule: the taxes became due more than 3 years prior to the petition date.
  • The 2-Year Rule: the tax returns were filed at least 2 years prior to the petition date.
  • The 240-Day Rule: the taxes were assessed at least 240 days prior to the petition date.

How are Tax Obligations Discharged?

Tax obligations are discharged upon the entry of the Bankruptcy Discharge Order. If a tax obligation is dischargeable, the discharge is the same as it is for any other dischargeable debt. BUT, if counsel is unsure about how a tax obligation may be treated in the bankruptcy, an adversary action can be filed to determine the dischargeability of the debt.  Equally important is that the IRS has rights as well to determine the dischargeability of the debt.  Competent counsel is vital to analyze tax obligations that do not fit neatly into the Bankruptcy Code because of their peculiar facts or legal application.

We are Here to Help You

The lawyers at Musi, Merkins, Daubenberger & Clark, L.L.P. can provide guidance and assistance in determining which may debts be eligible for discharge. If you or your business is experiencing significant financial difficulties related to income taxes, and other debts, and are exploring the possibility of bankruptcy, call our office and our experienced bankruptcy counsel can help navigate these important, but nuanced aspects of bankruptcy law.