Bankruptcy and Tax Debt Discharge
Filing for bankruptcy might not be the best way to resolve tax debt. But, depending on your individual circumstance, bankruptcy might be the best option. Change your mind that bankruptcy is only negative and ruins your credit. Instead, think about how it can help you with your current tax problem, relieve stress, and get you back on the right track.
Can tax debt be discharged in bankruptcy?
In general, bankruptcy does not discharge taxes unless it meets several exceptions. With this in mind, bankruptcy can have a great beneficial impact on resolving tax and other debts. Bankruptcy will not discharge all taxes, but it can help get you in a position to arrange a payment plan to settle the remaining debt.
Be sure to consult with a bankruptcy attorney who has full knowledge and understanding of the bankruptcy laws. They can discern what is dischargeable and what can determine what is best in filing a chapter 7, 11, or 13.
What are the various types of bankruptcy?
Chapter 7 – This is a where the taxpayer is seeking to have their debts discharged without any repayment plan to follow. Certain conditions must be met to qualify for the discharging of taxes. In a Chapter 7 business bankruptcy, the filing is done with the knowledge that a complete liquidation of the business assets will be done and creditors paid.
Chapter 11 – Used primarily for restructuring of business debts, although individuals also use it for personal debt. This allows the debtor to discharge the debt that is dischargeable, and then restructure or reorganize the remaining debt into a payment plan that is overseen by the bankruptcy trustee.
Chapter 13 – Is a plan for debt reorganization and repayment to creditors. Designed for individuals who wish to pay back their creditors. Generally, the payment plans must be paid in full within 60 months, though creditors could extend the repayment period.
Potential benefits of bankruptcy to resolve tax debt.
Bankruptcy can provide the benefit of having another way of resolving a tax issue. Some examples are automatic stay, discharge of taxes, interest, penalties, and forcing the government to accept a payment plan. The payment plan is through bankruptcy trustee, not the IRS Collections.
The Automatic Stay
Upon the filing of a bankruptcy petition, all collection activity by creditors must cease. This includes the IRS and state tax agencies. So, there is the immediate benefit of stopping the IRS and state from collection efforts against the taxpayer. Bankruptcy will effectually remove the case from the IRS Collections Division and move it to the IRS Insolvency Unit.
This gives the taxpayer immediate relief from collections pressure and can now work out a plan through bankruptcy. The IRS may not have been willing to work with the taxpayer in the same manner before the bankruptcy.
Discharging Taxes
The discharging of tax debt as opposed to unsecured debt can get complicated and it depends on a number of factors. Several factors determine if taxes can be discharged or not. These factors include the type of tax, its age, filing date, and events that occur after filing.
In a Chapter 7 bankruptcy filing, there are rules for determination of tax dischargeability. To discharge a tax obligation, these must be satisfied.
Three-Year Rule – The tax debt in question must be more than 3 years old. This is dated from when the tax return was due to be filed. Generally, the due date would be April 15th, or October 15th with an extension filed. The calculation does not consider the actual filing date.
Two-Year Rule – A tax return that is filed late needs to have been submitted at least two years prior to the bankruptcy filing.
240 Day Rule – The related tax debt must have been assessed more than 240 days before the bankruptcy petition date. If an Offer in Compromise is pending, then that time is added to the 240 days plus 30 days. When an amended return, examination of a return, or audit results in an additional assessment, a new 240-day period is applied to the increased assessment. The original tax that was dischargeable would still be dischargeable.
Non-Fraudulent Return Rule – The tax return for the year in question must be non-fraudulent. The IRS will generally consider the following in determining fraudulent or non-fraudulent.
- Knowledge of falsehood of the tax return
- An intent to evade taxes
- An underpayment of taxes
Non-Evasion Rule – The taxpayer must not have willfully attempted to evade or defeat taxes. The courts only need to establish the following to prove that taxpayer willfully attempted to evade of defeat taxes:
- Taxpayer (debtor) had a duty to pay the tax
- Taxpayer knew of the duty to pay the tax, and
- Taxpayer voluntarily and intentionally violated the duty to pay the tax
The mere act of not paying taxes is insufficient proof of evasion. It requires the willful act to evade or defeat the collections of taxes.
Unassessed Income Taxes – All tax must have been assessed as of the petition date to be dischargeable. If the tax is dischargeable but the IRS can still examine the related tax year, any additional assessment after the submission date will not be eligible for discharge.
Payroll, Withholding, and Other Trust Fund Taxes – Tax that is required to be collected or withheld for which the debtor is liable is a trust-fund tax and is ordinarily not dischargeable. This would include federal and state payroll withholding taxes and sales tax.
Property Taxes – Property taxes are dischargeable if they are assessed and payable without penalty more than one year from the bankruptcy petition date. If the same takes place within one year, property taxes are not dischargeable.
Employment, Excise Taxes, and Custom Duties – There are certain employment and excise taxes that are not dischargeable. If these are imposed on transactions within three years of the petition, they are not dischargeable. Customs duties that arise out of the importation of merchandise are also non-dischargeable.
Gap Claims – This refers to a scenario where the taxpayer is compelled into bankruptcy by their creditors, and subsequently faces a tax claim from the creditor prior to the appointment of a bankruptcy trustee or before the relief order is issued. This would be the “gap period” and claims in this period are not dischargeable.
For more information regarding Bankruptcy and Tax Debt Discharge, please contact Dan Ohara at (408) 684-8505 or email at dan@oharataxresolution.com.