Chapter 7 Bankruptcy
When taxes are dischargeable in bankruptcy
The rules regarding taxes and other debts are complex and confusing when it comes to bankruptcy. Whether a tax debt can be discharged (i.e. waived, forgiven, erased) as a result of filing bankruptcy depends on many factors. Such factors include the kind of tax, age of tax, whether a tax return was filed on time or at all, and the type of bankruptcy.
The first step in deciding whether or not to file a tax bankruptcy is whether the taxes are dischargeable or not.
Chapter 7 bankruptcy cases
Generally, a person files a chapter 7 bankruptcy in order to get out from under crushing debt problems and get a “fresh start.” A chapter 7 is a liquidation case. The person filing the case (debtor) surrenders any non-exempt assets to the court (chapter 7 trustee) and those assets are used to satisfy the claims of creditors. The debtor is discharged from all dischargeable debts, meaning that debts that go unpaid are forgiven. There is an extensive list of non-dischargeable debts or debts that are excepted for discharge that are spelled out in the law.
Income taxes can be discharged in a chapter 7 case, but only if they are not priority taxes or are not excepted from discharged for other reasons.
Priority taxes cannot be discharged in a chapter 7 case.
Priority income taxes
Generally, income taxes are priority taxes if they meet either of two tests found in the bankruptcy law. Those tests are the so-called three year rule and the 240 day rule.
The three year rule means that if the tax return due date for the particular income tax year was less than three years before the bankruptcy is filed, then it is a priority tax. Note: If an extension was filed, the three year rule is calculated from the date of that extension. Also, under this rule, it does not matter whether the tax return was actually filed or not.
The 240 day rule means that if the income tax was assessed within 240 days before the bankruptcy is filed, then it is a priority tax. The date that any particular tax was assessed can be difficult to determine. Make sure you know when the tax was assessed before filing bankruptcy.
Other types of priority taxes
Certain taxes are always priority taxes regardless of any lapse of time. Taxes that are required to be collected or withheld for which the debtor is liable are always priority taxes. Such taxes include federal withholding and withheld FICA taxes and sales tax (and the related responsible person assessment).
Non-priority taxes excepted from discharge
Even though income taxes may not qualify as priority taxes, they still might be excepted from discharge for other reasons.
- Late filed tax returns: The taxes related to a tax return that was filed late are not dischargeable if the return was filed within two years before the bankruptcy case was filed.
- No tax return filed: The taxes related to any unfiled tax return that should have been filed, are not dischargeable.
- A fraudulent tax return: The taxes related to a fraudulent tax return are not dischargeable.
Chapter 7 cases can be very useful in discharging large amounts of income tax if the case is researched and planned correctly. The law provides for an extensive list of assets that can be declared exempt from the bankruptcy, such as the debtor’s residence and pension assets, but still allow his or her to dispose of that crushing tax debt.
However, a bankruptcy case can go horribly wrong if it is not properly researched and planned. Make sure your case is handled correctly. Contact us today for a tax bankruptcy consultation.