October Tax Season: Can Bankruptcy Get Rid of My Income Tax Debt?

Yes, if you meet certain conditions you CAN legally discharge—permanently write off—federal and state income taxes.

 

Taxes Are Different, But Not That Different

If you have ever heard that income taxes can never be discharged in bankruptcy, that’s just plain wrong. Sure, unlike most other debts you have to meet some strict conditions. But once the tax you owe meets those conditions, the IRS and the state taxing authority are in the same boat as your credit card creditor—they can never ever pursue that debt again.

So What Are Those Conditions?

The conditions for discharging an income tax are not all that complicated. And sometimes they are not all that hard to meet. Most of the time it just takes filing your tax returns and waiting out a certain amount of time. Admittedly, sometimes that’s easier said than done.

There are two main conditions:

1. The Three-Year Rule: Before filing bankruptcy, more than three years must have passed since the due date for the tax return for the tax at issue.

Knowing whether you have met this condition looks quite simple, and usually is. Every income tax that you might owe had a due date for the filing of its tax return. After determining that due date, count three years forward, and if your bankruptcy case is filed after that date you’ve met this condition.

Sounds straightforward enough. So if a taxpayer owes $5,000 in income tax for the 2010 tax year, with the tax return due on April 15, 2011, as long as his or her bankruptcy case is filed after April 15, 2013 this first condition will be met for discharging that $5,000. Right?

Not quite, because there are two very important details to add.

First, this person and his or her attorney need to be very precise about the actual date the tax return was due that year. For example, when April 15 falls on a weekend, it’s not actually due until the following business day, usually April 16 or 17. One or two days may seem minor but can make all the difference in a tax debt—like the $5,000 in the example—being completely discharged or still fully owed.

It so happens that the due date in the example was particularly unusual in that the tax return for 2010 was due on April 18, 2011. April 15 that year was a Friday, but tax returns were not due until the following Monday, April 18, because of an unusual holiday in the District of Columbia that happened to fall on that Friday, April 15! When cutting it close, it’s crucial to be precise.

Second, that three-year period actually starts to run when the tax return was “last due, including extensions.” So if the taxpayer got an extension of time to send in 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.

So in the example above if he or she got an extension to file the 2010 tax return until October 15, 2011, the three years would start then. Except that this October 15 fell on a Saturday, and so the tax return was not due until the following Monday, October 17, 2011. The bankruptcy would have to be filed after October 17, 2014 to meet this condition.

And that’s the most straightforward condition! Well, the second condition in some respects is actually simpler.

2. The Two-Year Rule: Before filing bankruptcy, more than two years must have passed since the date that you actually filed the tax return with the IRS/state.

While the first condition was tied to a legal due date and had nothing to do with your actions (other than whether you got an extension), this second condition is tied completely to your actions—when you submitted the tax return.

The only complication is in determining accurately when you sent in the return or, more precisely, whether and when the IRS/state received it. Unless you already have documented proof of that date, it’s usually wise to get that directly from the IRS/state to make sure.

There’s one other twist that doesn’t apply to most people but is worth mentioning. If a taxpayer doesn’t file a tax return at some point the IRS/state will likely process what could be seen as its own version of your tax return, something the IRS calls a “substitute for return.” That does not start this two-year period running. Only the tax return that the taxpayer submits counts.

So, in the example we’ve been using, if that 2010 tax return was not submitted to the IRS/state when it was due—with an extension—on October 17, 2011, but rather not until October 15, 2012, the taxpayer would need to wait two years past that, until after October 15, 2014, to file a bankruptcy to be able to meet this condition.

Two Other Conditions that Seldom Apply

Most of the time, those two conditions are all that apply and need to be met to discharge an income tax debt in bankruptcy. But there are two others that could potentially apply, and so must also be considered.

3. The 240-Day Rule: Before filing bankruptcy, more than 240 days must have passed since the date that the tax was assessed.

“Assessment” is the taxing authorities’ formal determination of your tax liability. Practically speaking, the IRS/state receives and reviews your tax return, calculates and either accepts or corrects the amount of tax due, with that last step being the assessment of the tax. 

The 240-day period is usually easily met because in the vast majority of times assessment happens within a few weeks after you submit the tax return.  In these situations the 240-day period runs long before the two-years-since-filing condition is met. So usually this 240-day condition is not an issue.

It is only relevant when assessment gets delayed in exceptional situation—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, making the 240-day period highly relevant.

Practically speaking, you and your attorney can get assurance about when the assessment was made by getting this information from the IRS/state at the same time that you get the tax return submission date from them.

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

This final condition is very seldom a problem. It arises only if you were materially dishonest on your tax return, by not including some of your income, or by intentionally claiming deductions or credits which you knew you were not entitled to, or by cheating the IRS/state in some other way.

If so, the tax at issue cannot be discharged in bankruptcy. Unlike the other three time-based conditions, there is no timing component to this one.

Practically speaking, if you believe you completed your tax return honestly, have not been accused by the IRS/state of tax fraud or tax evasion, and are not being audited, this fourth condition is highly unlikely to be a problem.

Conclusion

To finish with our example of the $5,000 owed in 2010 income taxes, if the taxpayer got an extension but then submitted that tax return a year after the deadline—let’s say on October 15, 2012, and assuming both that the IRS/state assessed the tax about a month later and that the tax return was not fraudulent, as long as the taxpayer files his bankruptcy case after October 15, 2014 he or she would discharge that $5,000, and any interest and penalties associated with it.