Discharging Debts: Federal and State Income Taxes

••• Which income taxes can be discharged in bankruptcy?. Getty Images

A bankruptcy case can be an effective tool in managing tax debt. But, determining which taxes can be discharged at any point is not easy. Timing, as we will see, is everything. Obtaining the advice and support of a qualified bankruptcy attorney or tax professional is vital to maximize the effect of a bankruptcy filing and to prevent costly and irreversible mistakes.

Factors in Determining Dischargeability of Taxes

Federal and state income taxes are treated similarly in a bankruptcy case.

Whether the income tax debt is dischargeable depends on several factors, including:

  • when the taxes were due
  • when the taxes were assessed
  • when the return was due
  • when the return was filed
  • whether the taxing authority filed a tax lien
  • whether the taxpayer committed fraud
  • whether the debt is for interest
  • whether the debt is for penalties

Obtaining Information on Past Taxes

Before these factors can be assessed, a tax professional will probably request past tax information on you from the taxing authority.

For state specific information, you will need to contact your state’s revenue department. The IRS maintains a handy page with links to appropriate agencies and phone numbers for each state: How to obtain a copy of past tax returns in all 50 states.

For federal taxes, you can obtain exact photocopies of past returns from the IRS by calling 800-829-1040 or submitting IRS Form 4506T. The IRS charges a fee for this service.

You can also get a copy of a Tax Return Transcript or a Tax Account Transcript for free. Transcripts for the last three years can be downloaded from the IRS site if you have an email address and a Social Security number. You can also obtain a tax transcript by mail. For more information and to start the process, visit the IRS’s web page Get Transcript at http://www.irs.gov/Individuals/Get-Transcript.

Be advised, however, that you will probably want to go back further than three tax years on your tax return transcripts to ensure that the IRS shows nothing outstanding for earlier years. This will be important in determining whether taxes are dischargeable. To obtain older tax returns, call the IRS at the number above or submit Form 4506T. Be sure to allow plenty of time. Those requests can take two weeks to two months.

Dischargeable Income Taxes

To discharge income taxes, the tax and the taxpayer/debtor must meet a number of requirements.

     The Three-Year Rule

To be dischargeable, the tax would have to arise from a tax return that was due (with all extensions) at least three years before the bankruptcy case is filed. For instance, if the taxes were due for the 2011 tax year, the return was due April 15, 2012. If you request an extension that expires on October 15, 2012, the Three-Year Rule is satisfied for a bankruptcy petition filed after October 15, 2015.     

     The Two-Year Rule

To be dischargeable, the tax return must have been filed at least two years before filing the bankruptcy. If the IRS files a substitute return because you did not file one, most bankruptcy courts will not allow the tax for that year to be discharged.

Some courts have determined that the taxes on a substitute return can never be discharged. Other courts have decided that the taxes can be discharged if you later file your own return to replace the IRS substitute return.    

     The 240-Day Rule

To be dischargeable, the taxing authority must assess the tax at least 240 days before you file your bankruptcy case. Assessing the tax is a process by which the taxing authority records your liability for the tax. This usually happens on April 15 or the date you file your return, whichever is later. Additional assessments can be made later if the taxing authority determines that you owe more tax.

The 240-Day Rule can be extended if an offer-in-compromise or another bankruptcy case is pending during that period.

Taxes that have not been assessed as of the bankruptcy filing date, but are assessable, are not discharged.

The IRS generally has three years to assess taxes. This will not generally be an issue in most bankruptcies because those taxes will also not be dischargeable under the Three-Year Rule for tax returns.

Nondischargeable Income Taxes

If the tax debt does not meet the Three- and Two-Year Rules for tax returns, and the 240-Day Rule for assessment of taxes, it will not be discharged. Furthermore, any taxes that are not dischargeable in a bankruptcy case will not be discharged in any subsequent bankruptcy case, unless the later case is a Chapter 13 that pays the outstanding taxes in full. This is one of the reasons why it is vital that you carefully consider the timing of the bankruptcy case to ensure that you are not inadvertently filing too soon. 

Fraud or Tax Evasion

If you file a fraudulent or frivolous return or if you are found guilty of evading tax laws, the taxes for those years will not be dischargeable.

Interest on Income Taxes

In general, if the underlying tax is dischargeable, the interest will also be discharged.

Penalties on Income Taxes

Penalties on income taxes are generally dischargeable if the underlying tax is discharged, unless the penalty is designed to reimburse the government for money that it actually lost due to your failure to pay taxes. If the tax is older than three years (see the Three-Year Rule above), but cannot for some reason be discharged, the penalties will usually be discharged nevertheless.

Tax Liens

If your taxes pass all the dischargeability tests (the Three- and Two-Year Rules, the 240-Day Rule, and are not fraudulent), you may still find yourself with a tax that will not go away in bankruptcy. This will happen when if the taxing authority files a lien against your property before you file bankruptcy.  

A lien turns an unsecured debt (like a credit card or medical bill) into a secured debt (like a car or house loan). It means that the IRS or other taxing authority is claiming an interest in your property. It will allow the taxing authority to seize and sell your property to pay the taxes you owe.

The tax lien is effective, however, only to the extent of the value of the property. If you have little or no property, the tax lien will not net much money for the taxing authority, and the remainder will be discharged, provided all the “rules” have been met.

The IRS will not seize your property while you are in a bankruptcy case without permission of the bankruptcy court. With a tax lien, however, after the case is completed, the IRS may potentially seize and sell your property, even if the property was claimed exempt in the bankruptcy case.

Timing Considerations of Discharging Taxes in a Chapter 7 Bankruptcy

If you are a debtor who carries tax balances from year to year, timing a bankruptcy case can be tricky. You and your tax advisers must have a firm handle on what you owe, when you filed your returns and extensions, and when the taxes were assessed. You must also consider your future liabilities to determine if waiting to file bankruptcy might be a better option. Finally, you must consider the possibility that the taxing authority might secure payment of an otherwise unsecured tax debt by filing a tax lien against your property before you can file your bankruptcy case.

For more information:

To learn more about the debts that can and cannot be discharged in a bankruptcy case, be sure to visit these pages:

Discharge Overview

Discharge vs dischargeabilityChallenging the general discharge and discharge of particular debts

Dischargeability of particular debts

Discharging car loans, home loans and other secured debt

Reaffirmations and other exceptions to discharge

Litigating discharge challenges