Can you discharge your tax debt through Bankruptcy?
By: Gary P. Bluestein, Esq.
The general view of most accountants and attorneys we talk to is that tax debt is not dischargeable in Bankruptcy. When we tell them that a tax debt may indeed be dischargeable, people are typically very surprised. While there are many factors that determine whether a tax debt is dischargeable in a bankruptcy filing (primarily the type of tax debt and the timing of the bankruptcy), there are also many misconceptions as to what taxes can be eliminated. So, the short answer is: Yes, taxes can be dischargeable through bankruptcy, sometimes.
Like other creditors, the IRS must file a “Proof of Claim” when a bankruptcy is filed. Here we discuss the status of the tax claim which can fall into three types of claims: secured, priority, and general unsecured. Secured and priority claims present some problems in discharging tax debt, while the third type of claim, unsecured claims, may be eligible for discharge.
I. Secured Claim
The best status for any creditor’s claim in bankruptcy, would be a secured claim. To be secured, the creditor must have a pre-bankruptcy perfected lien on equity in an asset or assets. The IRS possesses a lien on all property once a tax liability is assessed. However, in order for the IRS to enjoy secured status in a bankruptcy, the lien must have been perfected by recording a Notice of Federal Tax Lien in the location required by local law. This normally is the County Clerk’s Office where the taxpayer resides and the Secretary of State. If the IRS has a perfected secure claim before bankruptcy, regardless of other timing issues discussed below, the IRS would need to be paid in full to the extent of the equity in the assets involved. It should also be noted that the Bankruptcy Code allows a debtor to claim as exempt certain assets, such as an IRA and a homestead exemption relating to their residence. The specific exemptions may vary based on state law. Unfortunately, however, these exemptions do not apply to the IRS. Therefore, even if the asset is claimed as exempt from the bankruptcy proceeding, and the underlying tax meets the requirements for dischargeability as discussed more fully below, if the IRS has a pre-petition perfected lien, that lien will stay on the asset. The IRS then can pursue collection against the exempt asset after bankruptcy.
Thus, clearly timing is critical; and if possible, bankruptcy should be filed prior to the IRS recording a Notice of Federal Tax Lien. However, a debtor must wait the appropriate time-frame to discharge income taxes as explained below.
II. Priority Taxes
Even if the IRS does not qualify as a secured creditor, the taxes will be excepted from discharge if they qualify as a priority tax claim.
Any trust tax (a collected tax for the government) is considered a priority tax claim. This includes payroll withholding tax which has been personally assessed against the debtor (see I.R.C. §6672), as well as state sales tax. Unlike trust fund taxes, the determination as to whether other income tax liabilities qualify as priority is more complicated. There are basically three rules that determine if a tax qualifies for priority status. These rules are as follows:
- The Three Year Rule— If the tax liability relates to a return that was due within three years of the filing of a bankruptcy, it will qualify as a priority tax and therefore be excepted from discharge. This rule runs from the due date of the return, taking into account extensions.
- The 240 Day Rule—If the tax is assessed within 240 days of filing the bankruptcy, it will be a priority tax. If an Offer in Compromise (a procedure to try to settle a tax liability with the IRS) is submitted during this 240 day period, and it ultimately is not successful, the time that was remaining on the 240 days when the offer was submitted, plus 30 days, is added in calculating whether the tax qualifies for priority status.
- The Tax is Not Assessed But legally Assessable—There can be situations where the IRS has an extended time to assess a tax. This could be due to Tax Court litigation, a signed agreement extending the assessment period, or a 25% omission of income extending the time to assess to six years (as opposed to the normal three-year time period).
There are also actions that can stop the timing periods referenced above from running, such as a prior bankruptcy or the request for what is referred to as a “Collection Due Process Appeal” filed in response to a Final Notice of Intent to Levy. Either of these actions will toll the priority timing periods while the matter is pending, plus an additional 90 days.
If the tax lien does not qualify as secured or priority, it may be dischargeable as general unsecured. However, even taxes in this category can be excepted from discharge if the taxpayer failed to file a tax return or filed the return late and the bankruptcy was filed within two years of the date of the delinquent filing. (It should be noted that state taxing authorities have successfully argued in some jurisdictions that an assessment relating to a late return can never be discharged. Although the IRS has not asserted this position, they have successfully argued that an assessment based on a Substitute for Return can never be discharged.) Lastly, if the tax involved relates to fraud or evasion, the underlying tax and interest relating thereto can never be discharged.
The goal of bankruptcy when income taxes are involved is to time the filing so the liabilities do not fall into the secured or priority category. Under these circumstances, the tax can be classified as general unsecured claim with no special status, and therefore potentially dischargeable if not excepted under any other provision. Although, as can be seen from the discussion above, there are significant hoops to get through in order to qualify an income tax liability for discharge and timing is critical. Nevertheless, the complications can be navigated and bankruptcy is often a tremendous tool to resolve an outstanding tax liability.
The information here provides only a general overview and there are many strategies and nuances that should be considered when addressing the taxing authorities in the bankruptcy context. The attorneys at Andreozzi Bluestein have extensive experience navigating the elimination of tax debt through Bankruptcy. If you think you or a client may be able to take advantage of this opportunity, please call us today with no obligation.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decision of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult an independent licensed attorney before making any decision or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Andreozzi Bluestein LLP and the recipient.
Any links to other web sites are not intended to be referrals or endorsements of these sites. The links provided are maintained by the respective organizations, and they are solely responsible for the content of their own sites.