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Discharging Income Taxes through Chapter 7 Bankruptcy

by Adam Weiner

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Income tax debts CAN be “discharged” (permanently written off) if they meet certain conditions.  These conditions may be quite easy to meet.

To write off income taxes under either Chapter 7 or Chapter 13 takes meeting four conditions. Two of these conditions are very seldom a problem. That means that most likely you can discharge a tax debt if you meet the other two conditions. And you will likely meet these other two conditions sooner or later. It’s mostly a matter of time.

The Two Main Conditions

1. The Three-Year Condition: More than three years has passed from the due date of the tax return until the bankruptcy filing date.

Every income tax has a due date for the filing of its tax return. So calculating when this condition is met is quite straightforward.  It is important to be precise, making sure to account for modest differences in some tax return due dates, specifically when the due dates are not on the usual April 15 date because that year it fell on a weekend. For example, for the 2005, 2006 and 2011 tax years, the tax return due dates were April 17, 2006, April 16, 2007, and April 16, 2012, respectively.

The 2010 tax year was extra unusual. April 15, 2011 fell on a Friday, but tax returns were not due until the following Monday, April 18.  (Also some people may be affected by administrative extension given for natural disasters and similar events. For example, the IRS has recently granted a six-month extension to families affected by the huge mudslide near Oso, Washington.)  Especially when cutting it close in filing the bankruptcy as soon as possible because of pressure from creditors, your attorney needs to be very careful to know the exact due date for the tax year(s) at issue.

There’s a very important twist here: the three-year period begins ONLY at the point in time when the tax return was “last due, including extensions.” So if you requested an extension of time to submit the tax return—from April 15 to October 15, usually—the three-year period does not begin until the extended due date for filing the tax. And again sometimes that extended date is a few days after October 15 because of weekends and such.

2. The Two-Year Condition: More than two years have passed from the date the tax return was actually submitted until the bankruptcy filing date.

Regardless when the tax return was due, more than two years must pass after the tax return was in fact filed with the IRS or Oregon Department of Revenue (ODR), whichever is applicable. 

Also, this two-year period does not start running until the tax return is submitted to the taxing authority by you. An administrative filing by the IRS or the ODR—a “substitute for return”—is a procedure by which the taxing authority in effect prepares what could be considered a partial tax return for you based on whatever information it has available. These do NOT start this two-year period running. 

It is advisable to file tax returns by the due dates (even if there will be a tax liability) because if the IRS files a “substitute for return” before the taxpayer files the taxes for that year, then the IRS may argue that those taxes are never dischargeable.  This is an undecided area of law, but it is best to file taxes on time and then make payment arrangements with the IRS and/or ODR (for state taxes).  (You don’t want to have to hire an attorney to litigate this issue if you file a bankruptcy after the IRS filed a substitute for return and the IRS is claiming that your taxes are not dischargeable for that reason.) The IRS is actually very easy to deal with in setting up voluntary payments.  The ODR usually wants the entire amount of their tax debt paid off over a 12-month period, but will set up a payment plan with you.  Indeed because of the possibility of discharging tax debts if they are three years old or older and the taxes have been filed at least two years before the bankruptcy filing, it is advisable to file taxes on time (even if there will be a balance owed).

The Other Two Conditions

3. The 240-Day Condition: More than 240 days have passed from the assessment of the tax until the bankruptcy filing date.

Assessment is the IRS/ODR’s formal determination of your tax liability, usually done through its review and acceptance of your tax return.  Usually assessment occurs within a few weeks after you file the tax return.  In those situations this condition is automatically met well before the two-years-since-filing-the-return condition is met. So usually this 240-day condition is meaningless, easily met.

So when could it possibly be relevant? When assessment gets delayed because of unusual circumstances, such as if the amount of a tax is in dispute because of a tax audit or litigation in Tax Court.  By the time the accurate tax amount is assessed, the two-year time period may have passed.  If so this third condition becomes relevant, only allowing the tax to be discharged if the bankruptcy case is filed more than 240 days after the day the tax is finally assessed. 

Also, be careful because this 240-day period is put on hold while a taxpayer’s “offer in compromise” is pending or is in effect.  That’s a settlement proposal made to the IRS (with a similar procedure for the ODR) to pay less than the full debt and/or to agree to certain payment terms.  The 240-day period is put on hold AND 30 days is added to it. The idea is that the time should not expire while the government is considering your offer, or while the agreement is in effect, and immediately after that. The 240-days-since-assessment period is also put on hold while the taxing authorities’ collection efforts are stopped by a prior bankruptcy filing, AND 90 days is added to it in this situation.

4. Fraud: Filing a fraudulent tax return or intentionally evading the tax.

Beyond the other three time-based conditions, there is this fourth one which has no time trigger. If you were dishonest on your tax return—such as failing to include some of your income, or intentionally claimed deductions or credits that you knew were not valid—or tried to avoid paying a tax in any other way, that tax can never be discharged in bankruptcy.

This condition is very seldom a problem. If you have been accused by the IRS or ODR of tax fraud or evasion, or if you have any concerns that you might be, raise this issue when you first see your bankruptcy attorney so that he or she can assess the likelihood that this condition will risk your ability to discharge the tax at issue.

Conclusion

The intersection of income tax and bankruptcy can definitely be complicated.  The information in this blog is for informational purposes only and should not be relied on in making any decisions. It is important to discuss your bankruptcy/tax issues with an experienced bankruptcy lawyer in Portland because everybody’s situation is different.  I routinely advise individuals on the tax implications involved with bankruptcy filings and other strategies, when appropriate, in dealing with tax liabilities. And I have successfully helped many debtors discharge significant amounts of federal and/or state tax debt.  Feel free to call my office to schedule a consultation.

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