One of the most common misconceptions in bankruptcy is that income taxes are never dischargeable. In fact, you can discharge some back federal and state income taxes in Chapter 7 and Chapter 13 bankruptcy matters. Likewise, the penalties and interest attached to those taxes are dischargeable. However, the dischargeability of income taxes is limited to a specific set of circumstances that was recently clarified by the Third Circuit Court of Appeals.
Dischargeability of Chapter 7 Income Taxes
Under Chapter 7 bankruptcy, five criteria must be met in order to successfully discharge federal and state income taxes. The five criteria are as follows:
#1) The Three Year Rule:
The tax debt must be related to income tax that was due at least three years prior to the bankruptcy filing;
Example: A debtor owes the IRS for 2010 income taxes. The debtor’s 2010 tax return is due to be filed with the IRS on April 15, 2011. The debtor timely file their taxes on April 15, 2011. The tax debt is eligible for discharge after April 15, 2014.
#2) The Two Year Rule:
The tax debt must be related to an income tax return that was filed at least two years prior to the bankruptcy filing;
Example: A debtor owes the IRS for 2010 taxes. The debtor filed a late return on September 1, 2013. The IRS has not filed a tax return or assessed the debtor’s tax liability on their behalf. The debtor’s tax debt is eligible for discharge after September 1, 2015.
#3) The 240-Day Rule:
The tax debt must have been assessed by the IRS at least 240 days prior to the bankruptcy filing;
Example: A debtor filed their 2008 tax return on April 15, 2010. The IRS assessed the taxes the same date. The debtor met the requirements of the 3-2-240 rules on April 15, 2012.
#4) The tax return does not contain fraudulent or misleading information; and
#5) The taxpayer cannot be guilty of tax evasion.
In Chapter 7, if the underlying tax obligation is dischargeable, the interest and penalties are also dischargeable. However, if the underlying obligation is non-dischargeable, then so are the related interest and penalties. Tax debts that rise from unfiled tax returns cannot be dischargeable. It should also be noted that despite the clear wording of the two year rule, there may be limitations on the ability of a debtor to discharge taxes arising from late-filed forms. We’ll discuss this issue and the recent Third Circuit Court Appeals opinion in a few moments.
If a debtor does qualify for an income tax discharge in a Chapter 7 bankruptcy case, the debtor may still be subject to prior recorded tax liens. A Chapter 7 bankruptcy will wipe out the personal obligation to pay the debt, and prevent the IRS from levying a debtor’s bank account or garnishing their wages, but if the IRS recorded a tax lien on the debtor’s property before they filed for bankruptcy, then the lien will remain on the property.
Dischargeability of Chapter 13 Income Taxes
In Chapter 13 bankruptcy, priority tax claims and secured tax claims must be paid in full through the Plan of Reorganization. Priority tax claims are tax debts that do not meet the Three Year Rule, whereas secured tax claims are tax debts where tax liens have been filed against the debtor’s property. However, secured claims are only paid in full up to the value of the debtor’s assets. As your bankruptcy attorney, we can bring an application under Section 506 of the Bankruptcy Code to determine what portion of the secured claim must be paid in full. If the five criteria discussed above are satisfied, the tax debts are treated as general unsecured debts and will likely receive minimal distributions.
Third Circuit Court of Appeal Recent Decisions Concerning Dischargeability of Taxes
In May 2017, the Third Circuit Court of Appeals in Giacchi v. United States (In re Giacchi) found that tax forms filed years after they were due and after the IRS had already assessed liabilities are not considered a “return” under bankruptcy law. Circuit Judge Jane Roth stated in the opinion for the Court, “[o]nce the IRS assesses the taxpayer’s liability, a subsequent filing can no longer serve the tax return’s purpose, and thus could not be an honest and reasonable attempt to comply with the tax law.”
As a result of the Third Circuit’s ruling, subsequent tax returns filed after an IRS tax assessment rarely qualify as an honest or reasonable attempt to comply with tax law and deadlines. As stated by the Court, “[t]his is because the purpose of a tax return is for the taxpayer to provide information to the government regarding the amount of tax due.” In other words, anyone seeking to discharge tax liabilities must continue to timely file their tax returns, or at the least, file their tax returns before the IRS independently assesses the debtor’s tax liabilities. Therefore, it is extremely important to by abide tax law deadlines if a debtor hopes to discharge income tax liabilities.
If you are considering filing for bankruptcy and aren’t sure if your tax liabilities are dischargeable, please contact one of our experienced attorneys to evaluate your individual case.
Whether you need to completely eliminate your debt through Chapter 7 bankruptcy, or need to reorganize your credit payments through Chapter 13 or Chapter 11, we are well qualified as a full-service bankruptcy law firm for people in these and other New Jersey counties: Passaic County, Hudson County, Essex County, Bergen County, Morris County, and Sussex County. Call us today at 973-870-0434 or toll free 888-412-5091.