Timing Bankruptcy to Discharge Income Taxes
Usually, you can discharge income taxes (write them off forever) by waiting to file bankruptcy long enough. Here’s how it works under Chapter 7.
Our blog post of two weeks ago introduced the importance of timing your bankruptcy filing right. We gave a list of 15 examples of timing considerations. Last week we started with the first one, timing the filing to cover as many debts as possible. Today it’s about discharging/writing off income taxes, specifically under a Chapter 7 “straight bankruptcy.”
Here are a few eye-catching facts:
- It is possible to discharge many income tax debts so that you do not owe a dime of that tax.
- You just have to meet a list of conditions.
- Most, but not all, of those conditions involve the passing of time. You need to wait long enough before filing bankruptcy to permanently discharge tax debt.
- If you don’t meet the conditions, bankruptcy does not discharge the tax at all. You owe it in full. If you filed a Chapter 7 case, you have to pay the tax after completing the case.
- In that situation, you’d also have to pay the continuously incurring tax interest and penalties.
- But if you do meet the conditions, your Chapter 7 case will discharge the entire tax. You will owe nothing after your case is finished (usually only about 4 months after filing it).
- You will also not owe any of the related tax interest or penalties.
- There are various additional factors—such as recorded tax liens—that can complicate the situation and the tactics involved.
Timing is Often Crucial
Although there is a list of conditions, often the ones that matter are the ones involving timing. Specifically, they pertain to when you file your Chapter 7 case.
Much of the time a Chapter 7 case will discharge an income tax debt if you meet two-timing conditions. The date that you and your bankruptcy lawyer file that bankruptcy case must be both:
- at least 3 years after the tax return for that tax was due, and
- at least 2 years after that tax return was actually submitted to the IRS or state tax authority.
See Section 507(a)(8)(A)(i) of the U.S. Bankruptcy Code for this first timing condition; section 523(a)(1)(B) for the second.
Note: Regarding the first 3-year condition above, add any time given through an extension to file the pertinent tax return. Section 507(a)(8)(A)(i) of the Bankruptcy Code. For example, assume you got the usual 6-month tax return extension from April 15 to October 15 for the pertinent year. Then you don’t start the 3-year time period until that October 15 instead of April 15.
Applying these Timing Rules
These two timing rules will make more sense when applied to an example.
Assume the following. You:
- owe $10,000 in income taxes for the 2016 tax year, plus a bunch of accruing interest and penalties
- had asked for a 6-month extension to October 15, 2017 (actually to October 16 since the 15th that year was a Sunday)
- actually did not submit the tax return until December 1, 2017
If you file a Chapter 7 case before October 16, 2020, you would not discharge the $10,000 tax. You’d continue to owe the $10,000 tax, plus the accruing interest and penalties.
However, under many circumstances, if you file on or after October 16, 2020, you would discharge all of the $10,000. You would no longer owe any of it, including the interest and penalties.
Why the total difference? Because as of October 16, 2020:
- At least 3 years would have passed since the extended tax return due date of October 16, 2017, and also
- At least 2 years would have passed since actually submitting the tax return on December 1, 2017.
Earlier we said that are other conditions to meet besides the two-timing ones referred to here. So what are those other conditions that would result in an income tax not being discharged, even after meeting the above 2-year and 3-year conditions?
There are three other conditions or situations to look out for:
- Tax Fraud or Evasion: The Bankruptcy Code says you can’t get a discharge of a tax for which you “made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” Section 523(a)(1)(C). The problem is that language is quite vague. So bankruptcy judges interpret this language differently. For example, is it a willful attempt to evade a tax if you don’t submit the tax return when due, even if you submitted it voluntarily a year later? Talk with your bankruptcy lawyer about how your local bankruptcy court interprets this language.
- Income Tax Liens: Once the IRS or state tax agency records a tax lien, that puts a legal cloud over either all your personal or real property, or both. Depending on what you own, that can turn a tax debt that bankruptcy will discharge in full into one that you still have to pay in full or in part. A tax lien creates complications that you need to thoroughly discuss with your bankruptcy lawyer.
- Offer in Compromise/Prior Bankruptcy: Have you made an “offer in compromise” to the IRS or state to settle the debt? Have you filed a prior bankruptcy case involving this same tax debt? Under these rather unusual circumstances, there are some additional timing rules. Tell your lawyer if either of these circumstances applies to you, in order to meet the special rules.
Assuming these three special conditions do not apply, and you’ve met the 2-year and 3-year conditions, a Chapter 7 case should discharge your tax debt.