Contrary to popular belief, a taxpayer may discharge income taxes in bankruptcy as long as the bankruptcy is not filed too soon after the tax return is filed. As a general rule, you can discharge income taxes that become due more than 3 years before filing bankruptcy, as long as it has been at least 2 years since you filed the tax return and more than 240 days since the taxes were assessed.
Bankruptcy is a game of timing. File a case one day too soon and the taxes are not discharged. File a day later and all of the tax is discharged. A wise bankruptcy attorney and an educated client will want to verify the assessment date of the income taxes owed by obtaining an Account Transcript for each year taxes are owed. IRS Form 4506 provides a taxpayer with a free copy of their account transcripts.
To discharge income taxes in bankruptcy, a few rules need to be observed:
- Only income taxes and taxes on gross receipts may be discharged. Payroll taxes are not dischargeable in bankruptcy.
- No Substitute Returns: The taxpayer must actually file the return to discharge the tax. If the IRS files the return (sometimes called a SFR or “substitute for return”), the tax is not dischargeable.
- Three-Year Rule: The taxes must have been due more than three years prior to filing bankruptcy.
- Two-Year Rule: The tax return must have been filed more than two years before filing bankruptcy. So, if you filed a return a few years after it was due, the return must be on file with the IRS for at least two years before it can be discharged.
- 240-Day Rule: The taxes must have been assessed more than 240 days prior to filing bankruptcy. This rule comes into play when the IRS audits a tax return and assesses additional taxes or penalties. So, if the IRS audits your return filed 5 years ago and assesses new taxes and penalties, you must wait another 240 days to file the bankruptcy.
- Fraud & Tax Evasion: If a taxpayer may not discharge taxes when they commit tax fraud or if they willfully evade taxes.
- Offer in Compromise: If a taxpayer files an Offer in Compromise before the time rules above have expired, the above timelines are extended by the time an Offer in Compromise is pending plus 30 days.
- Tax Liens: As a general rule, bankruptcy cancels debts and not liens. So, even though a tax may be old enough to discharge, the tax lien will remain on the taxpayer’s property despite receiving a bankruptcy discharge. In Chapter 7 cases, the mixture of tax liens and assets with equity—regardless of whether an exemption law normally protects the asset—becomes lethal with the application of Bankruptcy Code Section 724(b). The IRS is not subject to state exemption laws, and Section 724(b) gives the Chapter 7 Trustee special powers to liquidate assets if a tax lien is present.