Income taxes can be legally written off in bankruptcy under the right conditions. With careful planning, you can meet those conditions.
The Conditions for “Discharging” (Writing Off) Taxes
Income taxes that don’t meet certain conditions at the time your bankruptcy case is filed will not be discharged at the end of that case. Those taxes that do meet those conditions will be discharged.
Most of the required conditions involve taking certain action (such as filing the pertinent tax return) and waiting a certain minimum amounts of time to pass after certain events (such as the date when the tax return was actually sent in).
The rules of pre-bankruptcy planning that flow from this are the following:
1. Find out the Precise Date When You Can Discharge Each of Your Tax Debts, and Act Accordingly
The starting point of pre-bankruptcy tax strategy is for you and your attorney to determine exactly when each of your tax debts will be dischargeable. Sometimes that’s quite easy to do, but often it takes some work. For example, the date the tax return was due for discharge purposes includes accounting for any extensions, so it’s critical to know whether a particular tax return was filed after being granted an extension. Otherwise the bankruptcy could be filed too early, so that you would continue owing the tax in full instead of it being discharged in full.
Then after finding out exactly when a tax could be discharged, you need to take all the appropriate steps to delay filing your bankruptcy case until then. That involves handling your debts in general, and your tax debts in particular, the right way.
There are almost always disadvantages to waiting until you get the hoped for advantage of discharging your tax debts. These can be financial disadvantages—such as money paid to creditors to keep the peace with them in the meantime—and more intangible disadvantages—such as the lack of peace of mind from putting up with pressure from your creditors while you wait.
So you need solid legal advice and counseling in weighing the advantages and disadvantages of waiting or not waiting.
2. File Past-Due Tax Returns
You may have avoided filing a tax return when you knew you owed taxes on that return, taxes you knew you could not pay. But that won’t work if you want to write off your tax debts (or at least some of them) in bankruptcy. That’s because you can’t discharge an income tax until 2 years has passed after you filed the return.
Because of this, you usually should file your tax returns as soon as you can. And yes, that will trigger action by the IRS and/or the state. So you will certainly need to get advice about the best way to deal with them in the meantime to protect yourself, your income, your home and possessions.
3. As Much As Possible Pay New Taxes Instead of Old
As you hold off on filing your bankruptcy case, try to not accrue new income tax debt since that likely won’t be able to be discharged once your bankruptcy is filed (since it will likely be too new to meet the conditions).
Keep current by having enough withdrawn from your current paychecks. And if you are self-employed or operate a small business, pay the appropriate amount of estimated quarterly taxes. But do not over-withdraw or pay too much estimated taxes, because any tax refunds will go into the black hole of your oldest tax debts, the ones you hope to discharge.
Whenever you pay any current taxes, give clear instructions that is what the payments are for, to avoid them being earmarked for the older taxes. Stay current on current taxes because that helps avoid having the taxing authorities get aggressive with you, more easily allowing you to put off filing bankruptcy and discharge more taxes.
4. Don’t Engage in Tax Fraud or Tax Evasion
Taxes associated with fraud, fraudulent tax returns, or tax evasion can never be discharged, regardless how long you wait. These involve failing to disclose income, claiming tax deductions or tax credits that you are not entitled so, and any other attempt to avoid paying the appropriate amount of income taxes.
If you have any concerns that you might have engaged in any such behavior, tell your bankruptcy attorney right away. You may very well be unnecessarily concerned. But if you are likely to be accused of such behavior, it would likely not make sense for you to put a lot of effort and time into waiting to file bankruptcy only to have it do no good.
Since tax fraud is not something most people engage in, so this is not often a problem.
5. Pay Past and Current Trust Fund Taxes
If you are an employer, trust fund taxes are those that you would withhold from an employee’s paycheck, hold in trust, and then must send to the IRS/state. If you fail to pay those withheld fund and owe such taxes, they can never be discharged.
So if you are responsible for paying any such trust fund taxes, do everything you can to pay them as soon as they are due. Among other things, the IRS/state are especially sensitive to people not paying such trust fund taxes and so will tend to be very aggressive in their collection efforts against you and your business. So it would be hard for you to hold off on filing your bankruptcy, with the result that you would not be able to discharge income taxes that you’d hoped to discharge.
6. Watch Out for Recorded Tax Liens
The recording of an IRS or state tax lien before your bankruptcy filing at the very least creates complications, and at worst can turn a tax that would have otherwise have been discharged and not paid anything into one that has to be paid in full. Clearly, you want to avoid having the IRS/state record a tax lien against you. You also should take steps to minimize the harm of a tax lien if one is recorded.
As for avoiding a recorded tax lien, frankly you may not have much control over when the IRS/state decides to exercise its discretion and record one. But they have policies about when they record a tax lien. They tend to be triggered by a perceived lack of cooperation and/or the raising of certain red flags (such as when the total tax debt exceeds a certain amount). But the authorities usually have a certain amount of discretion, so when they take this action can be difficult to predict. Your attorney will inform you about the effect of a possible tax lien recording in your own situation, how to reduce the risk of it happening, and how to adjust your overall game plan in light of this concern.
Given the possibility of a tax lien, sometimes you can reduce its effect during the time you’re waiting to file your bankruptcy. You do that whenever possible by not building up equity in your home or your possession, thereby giving a potential tax lien no equity or less equity to attach to. Any equity you build up just tends to increase what you would have to pay to the IRS/state on taxes that you could otherwise discharge altogether.