Five Important Bankruptcy Rules You Must Know When Dealing with Tax Debt

By: Joshua M. Kin

Tax debts can be crippling; they often snowball out of control with penalties and interest. And while many prefer to ignore their growing income tax debt, rather than attempt to deal with the taxing authority, the IRS and other taxing authorities are not your typical creditors. They have increased powers to levy and collect on tax liabilities that other creditors simply don’t have. Thus, dealing with your tax obligations is important. But keeping up with your tax obligations—besides the stress it creates—can also cause you Bankruptcy Rulesto fall behind on other bills and loans. So what’s the solution?

Contrary to popular belief, many income tax debts (state or federal) can be discharged in bankruptcy—it’s just not easy. The liability for each tax year must be analyzed to determine whether an income tax debt is dischargeable. To be dischargeable, the income tax debt must meet the following criteria:

  1. Three-Year Rule.  The income tax debt must be more than three years old. This period is measured from the time of the bankruptcy filing to the date the income tax return was last due, including all extensions. The actual filing date is immaterial.

Example #1. Providing the taxpayer did not request an extension, any tax owed for tax year 2011 is not dischargeable unless the bankruptcy petition is filed on or after April 16, 2015. After April 16, 2015, all income tax debt incurred on or before 2011 is eligible for discharge in bankruptcy.

2. Two-Year Filing Rule. To be dischargeable, the taxpayer must file the tax return more than 2 years before the bankruptcy is filed. While the Three-Year Rule deals with the age of the tax, the Two-Year Filing Rule focusses on when the tax return was actually filed. Thus, while a tax debt may qualify under the Three-Year Rule, if the taxpayer hasn’t filed their return two years prior to the bankruptcy, the income tax debt will not be dischargeable.

Example #2. The taxpayer filed a tax return for the 2008 tax year on April 16, 2014. This income tax debt qualifies under the Three-Year Rule, but in order for this income tax debt to be dischargeable, the taxpayer must wait until April 16, 2016 to file their bankruptcy petition.

  1. 240-Day Assessment Rule. An income tax debt is not dischargeable unless the tax was assessed more than 240 days before the taxpayer files for bankruptcy. This time frame can be affected by audits or offers of compromise. Thus, it is important to keep an accurate history of dealings with the taxing authority.

Example #3. The taxpayer filed a tax return for the 2010 tax year on April 15, 2011. As a result of a subsequent audit, the IRS assessed an additional tax on January 1, 2015. While both the Three-Year Rule and the Two-Year Filing Rules are both satisfied, the taxpayer will need to wait 240 days from January 1, 2015 to file a bankruptcy petition in order for their income tax debt to be dischargeable.

  1. Fraud and Evasion. Even if the income tax debt meets each of the above criteria, if the taxpayer committed tax fraud or is guilty of tax evasion, they are not eligible for discharge.
  1. Tax Liens Not Discharged. While your personal liability for income tax debt may be eliminated in bankruptcy, the bankruptcy will not eliminate a tax lien that was filed before the bankruptcy. Though the taxing authority cannot garnish your wages or seek other collection efforts to satisfy the tax lien, the lien remains attached to your property even after the bankruptcy. This simply means that the lien will typically need to be paid at or before the sale of your property.

The bankruptcy rules dealing with the discharge of tax liabilities is complex and requires a thorough examination of your individual situation. Careful planning as to how and when you file for bankruptcy relief is important. If you are struggling with debt and want to organize your life, contact Joshua Kin at 937.223.1130 or via email at jkin@pselaw.com.

AUTHOR: Josh Kin
jkin@pselaw.com