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A quick primer on discharging income taxes in bankruptcy

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Are you a bankruptcy practictioner or curious taxpayer interested in whether income taxes will go away by filing a bankruptcy case? Well, the rules involved are notoriously tricky, but can be summarized as follows:

In order to discharge income taxes through bankruptcy, the taxpayer / debtor must qualify under three rules — the three year rule, the two year rule, and the 240 day rule — and then check for tax liens.

Let’s take them in turn:

Three year rule: The three year rule has to do with tax filing periods, instead of tax returns per se. The rule looks at how old the tax is by looking at the tax period involved. So: for a tax to be dischargable, the tax year must have had a deadline for filing (including all extensions granted) that fell than three years
before the day the bankruptcy case was FILED.

It works like this: Say the debtor owes taxes for tax year 2014. His return was due April 15, 2015. So he can wait three years and file for bankruptcy on April 16, 2018, right? NOOOOO — because there were holidays (Patriots Day, etc.) in 2015 that delayed the IRS deadline to April 17, 2015. So if the debtor filed for bankruptcy on April 16th, he’s just screwed himself. Trap for the unwary.

But this debtor requested the automatic six-month extension for filing that everyone can get. That means his return wasn’t due until October 15, 2015, and he can’t file a bankruptcy case to discharge the tax until after October 15, 2018. See ya next fall, or he’s screwed again.

Two year rule: Here is where we start looking at tax returns, not just calendar pages. The two year rule requires that in order to discharge a tax, the debtor must actually file his return more than two years before filing his bankruptcy case.

Implicit in the two year rule is that the return for the year in question must actually have been filed. Once filed, the debtor must wait two years before bankruptcy relief. When interviewing clients, you can turn this around. Ask them if they have filed a return for year X, and if the answer is no, the analysis is simple: The tax isn’t going away.

Some cases raise the question of what is a “return?” If the IRS files what they call a substitute return (or SFR) that doesn’t qualify as a return. Worse, some courts say that the substitute return blocks the debtor from filing his own return later, and so the tax will never be dischargable. Substitute returns are usually found with recalcitrant debtors who have had long running battles with the IRS.

240 day rule: If a tax is assessed by the taxing agency less than 240 days before the bankruptcy case is filed, the tax will not be discharged in the bankruptcy case. Debtors who are engaged in audits with the IRS or MDOR may be tripped up by this rule, as the audit may result in a new assessment. The rule also raises the question of how do you know when the tax has been assessed? Answer: the assessment date may appear on IRS or MDOR correspondence, it will appear on a taxpayer’s account transcript, or it may be obtained by calling the tax agency on the phone. Fortunately, avoiding the 240 day rule can be dealt with by a simple tactic: wait awhile before filing the bankruptcy petition.

Tax liens: Debtors who pass all three rules may think they have a clear path to getting rid of their tax problems through bankruptcy. Maybe so, but there is at least one more hurdle to climb: checking for tax liens. The general rule is that tax liens issued before a bankruptcy filing survive the bankruptcy, so that even if the debt is discharged through the bankruptcy process, the tax agency may still recoup the money if property is sold after the case is over. This is definitely a trap for the unwary — always check for tax liens before filing your bankruptcy case!

by Doug Beaton


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