Eliminating Tax Debts in Bankruptcy

Most taxes can't be eliminated in bankruptcy, but some can.

You may hear radio commercials offering the hope of eliminating tax debts in bankruptcy. But it's not as simple as it sounds. If a large part of your debt consists of federal taxes, what happens to your tax debts may determine whether Chapter 7 bankruptcy or Chapter 13 bankruptcy is a better choice for you.

When You Can Discharge a Tax Debt

If you are considering bankruptcy relief from tax problems DO NOT FILE delinquent tax returns until you talk to a bankruptcy professional.

You can discharge (wipe out) debts for federal income taxes in Chapter 7 bankruptcy only if all of the following conditions are true:

• The taxes are income taxes. Taxes other than income, such as payroll taxes, a Trust Fund Recovery Penalty, or fraud penalties, can never be eliminated in bankruptcy.

• You did not commit fraud or willful evasion. If you filed a fraudulent tax return or otherwise willfully attempted to evade paying taxes, such as using a false Social Security number on your tax return, bankruptcy can't help.

• You pass the "three-year rule." To eliminate a tax debt, the tax return must have been originally due at least three years before you filed for bankruptcy. This usually means April 15 of the year the return was due. But, if you filed a request for an extension, then it might mean August 15 or October 15 of that year. That is the date you start counting from.

• You pass the "two-year rule." You must have also actually filed the tax return at least two years before filing the bankruptcy (having the IRS file a substitute return for you doesn't count unless you agreed to and signed the substitute return). If you don't file a tax return, you can never discharge the taxes you owe for that year in a Chapter 7 bankruptcy. (You can, however, deal with the taxes in a Chapter 13 repayment plan.)

• You pass the "240-day rule." The income tax debt must have been assessed by the IRS at least 240 days before you file your bankruptcy petition, or must not have been assessed yet.

If any of the following situations apply to you, you will have to add time to the three-year, two-year or 240-day requirements for your debts to qualify for discharge in bankruptcy:

• You submitted an "offer in compromise" seeking to settle with the IRS for pennies on the dollar. An offer in compromise delays the 240-day rule by the period from the time from when the offer is made until the IRS rejects it or you withdraw it, plus 30 days.

• You obtained a "taxpayer assistance order" from an IRS problems resolution officer. If a taxpayer assistance order was issued preventing the IRS from collecting, the bankruptcy court may require that you add the time collection was suspended to the three-year, two-year and 240-day requirements. Not all courts require this, however.

• You filed a previous bankruptcy case. If you previously filed for bankruptcy, all three time periods -- three years, two years and 240 days -- stopped running while you were in the prior bankruptcy case. You must add the length of your case.

If you are considering bankruptcy, call the IRS (800-829-1040) to obtain a plain-English transcript, known as a literal transcript or IMF printout, for each tax year on which you might owe. This free computer printout lists important tax dates -- when the returns were filed, when the taxes were assessed, and the dates of any tolling or extending events. Make sure you check the dates from the IRS transcript before filing bankruptcy.

You may have to submit Form 4506T to IRS to get your transcript.  Ask for transcripts for the last ten years of tax returns – not just the year(s) you think are involved.

The Effect of Federal Tax Liens

You should be very careful in valuing the property you own in preparing your bankruptcy schedules if you have a tax lien filed against you.  While Chapter 7 will not eliminate the lien it will determine the “value” of their lien.

If your taxes qualify for discharge in a Chapter 7 bankruptcy case, your victory may be bittersweet. This is because prior recorded tax liens are not affected by your filing. A Chapter 7 bankruptcy will wipe out only your personal obligation to pay the debt, but any lien recorded before you file for bankruptcy remains. After your bankruptcy the IRS can seize any property they could have seized before the bankruptcy was filed.

But this doesn't mean that after your bankruptcy case is over the IRS will come and grab all of your property. After bankruptcy, the IRS tends to seize only real estate and retirement accounts or pensions. And even then, IRS seizures generally take place only when a taxpayer has made no efforts to otherwise resolve the problem. Furthermore, IRS collectors must obtain approval from their supervisors before seizing a house or pension. (The IRS is very concerned about negative publicity.)

(see also:  Tax FAQ   and  Top 10 Tips for Surviving an IRS Collection )