How Bankruptcy Handles . . . The Writing Off of Income Taxes with a Simple Chapter 7 Case

Here’s how straightforward discharging (legally writing off) income taxes can be in bankruptcy.

 

Our last two blog posts showed how a Chapter 13 three-to-five-year “adjustment of debts” case can help a person who owes income taxes that do NOT qualify for being discharged in a Chapter 7 “straight bankruptcy” case. Chapter 13 can be a great way to pay back taxes that you have to pay (usually relatively recent taxes), giving you very flexible terms, usually avoiding additional interest and tax penalties, and protecting you from the IRS and the state tax agency throughout the payment process.

But what if the income taxes that you owe DO all qualify for being discharged? How does a Chapter 7 deal with such taxes? We illustrate with the following example.

Our Hypothetical Taxpayer

Jeremy claimed too many exemptions during 2008, 2009, 2010, and 2011, and so did not have enough money withdrawn for his federal and state income taxes during those years. Then he started a new job at the beginning of 2012, claimed the right number of exemptions, and has had enough withheld since then.

He filed all four years’ (2008 through 2011) state and federal income tax returns on April 17, 2012 (the due date that year). His modest tax refunds since then have all gone towards his tax debt, plus in mid-2013 he was pressured to start monthly payment plans with the IRS and his state tax authority to pay his back taxes. In part because of those tax instalment payments Jeremy’s not been able to keep current on his credit and store cards, and his medical bills, plus a number of months ago his vehicle was repossessed. He owes $30,000 in credit and store cards, $15,000 in medical bills, and was just sued by his vehicle lender for $10,000.

He currently owes income tax, penalties and interest to the IRS and state in the amounts of $3,500 for 2008, $5,000 for 2009, $4,000 for 2010, and $3,000 for 2011, a total of $15,500 in taxes. Together with the rest of his debts, Jeremy owes a grand total of $70,500.

A Chapter 7 Bankruptcy Case Will Likely Discharge All His Taxes, All His Debts

 When Jeremy meets with a bankruptcy attorney he is pleasantly surprised to hear that most likely a Chapter 7 case would permanently discharge all his tax debts. It would also discharge all the rest of his debts. In a matter of only about 3 months he could be totally debt-free.

To discharge income taxes, Jeremy had to meet four conditions:

  1. More than 3 years must have passed between when the pertinent tax returns were due and the time he files his Chapter 13 case. His most recent owed tax, for 2011, was due on April 17, 2012. As long as Jeremy’s Chapter 7 case is filed after April 17, 2015, he meets this condition for the 2012 tax debt (as he already did for the earlier for the prior tax years.
  2. More than 2 years must have passed between when Jeremy actually submitted his tax returns to the IRS/state and the time he files his Chapter 13 case. Since he filed all the pertinent tax returns on April 17, 2012, he met this condition back in April of 2014.
  3. Jeremy must not have “made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” If he had done so, there would be no expiration of these offenses for bankruptcy discharge purposes, and he would never be able to discharge the tax. Since Jeremy did not hide any of his income nor did he complete his tax returns in any other false way, he met this condition. (Except in extreme situations, filing a tax return late is not considered to be tax evasion or tax fraud for discharge purposes.)
  4. A tax lien must not have been recorded on the taxes due. This last one is not actually a condition, but rather under certain circumstances the practical effect of a tax lien is to turn a tax you wouldn’t have to pay at into one that you may have to pay in part or in full. (This is a somewhat complicated area, which we addressed in a series of four consecutive blog posts back in mid-February—please check those out.) Likely because Jeremy does not own a home or anything else of meaningful value worth putting a lien on, and because his tax debt was not terribly high, AND because he was in a monthly payment plan and complied with its terms until his Chapter 7 case was filed, neither the IRS or state had recorded a tax lien against him.

Because Jeremy met these conditions, a little more than three months after his Chapter 7 case was filed he received a discharge of all of his debts. The discharge applied to his $15,500 in federal and state income taxes just the same as it did to his $30,000 in credit and store cards, his $15,000 in medical debts, and the $10,000 owed on his repossessed vehicle. With the discharge of all of these debts, his creditors—including the IRS and state—were forever forbidden from attempting to collect these debts. So Jeremy has a fresh start with no debt, including no tax debt.

 

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