Sometimes Yes, Sometimes No!
The Bottom Line? ALWAYS file your taxes on time, even if you can not afford to pay!
We all know that "Nothing is certain but death and taxes", but the fact is that back income taxes may not stay around as long as death. Let's look at when back income taxes may be discharged (eliminated) with a bankruptcy.
"Discharged" means they are eliminated, quickly in a Chapter 7 bankruptcy or over three or five years after making payments to the bankruptcy trustee in a Chapter 13 bankruptcy. It's the same for federal (IRS) or state income taxes.
Back income taxes owed are discharged in bankruptcy if they meet all of the following rules. This is not simple stuff because, as you'll see, there are "gotcha's" waiting in the wings.
1. The Three Year Rule
The tax return was due more than three years before filing bankruptcy.
For example, looking at tax year 2008, if there was no extension, you start counting on April 15, 2009, when the return was normally due. The bankruptcy for that tax year 2008 can be filed on or after April 16, 2012 to satisfy the Three Year Rule.
Note that the due date can include extensions (out to October 15), and also if the due date is the 15th and that day is a Sunday, then the due date is the 16th.
2. The Two Year Rule
The income tax return for that tax year must have been filed more than two years before filing bankruptcy. The Two Year Rule applies to all tax returns that were filed late, including those filed late without obtaining an extension that would have made the filing not late. Although the Three Year Rule above considers the age of the tax, the Two Year Rule only deals with the date the return was actually filed.
Late-filed income tax returns filed after the due date are considered filed on the date the taxing authority actually receives the return. The two-year time period starts to run on the date that IRS or California Franchise Tax Board actually receives the return.
Also, the IRS may file a substitute return for you if you don't file the return. You can consent to the return by signing it, or the IRS can file the return without your consent. If you don't sign the IRS-prepared return, it does not count as a filed tax return for purposes of the two-year filing rule. However, if you do sign the return, it will count as a filed return for purposes of the Two Year Rule.
3. 240 Day Rule
The income taxes were assessed (if they were assessed) by the IRS (or California FTB) more than 240 days prior to the bankruptcy filing.
4. The Fraud Rule
You did not file a fraudulent return or willfully attempt to evade paying taxes.
5. Events that Toll (Stop) the Time Periods
Certain events may interrupt the running of the three-year, two-year, or the 240-day rules. Essentially, any event that prevents the taxing authority from collecting the tax serves to toll the running of the respective discharge time limits.
Offers in Compromise: An offer in compromise extends the 240-Day Rule by the number of days the offer in compromise is pending, plus an additional 30 days.
Prior Bankruptcies: The filing of a bankruptcy also tolls the 240-day rule. If a debtor files bankruptcy, the 240-day time period is extended by the number of days the bankruptcy is pending, plus an additional 90 days.
Request for a "Due Process" hearing: Both the three-year rule and the 240-day rules are tolled if a taxpayer makes a request for a due process hearing after a notice of assessment pursuant to IRC §§ 6320, 6330.10 The amount of time that the rules are tolled is equal to the full amount of time that the appeal was pending plus 90 days.
Tax Installment Plans are not tolling events. You can make installment plan payments with the IRS and then file bankruptcy after the time limits have run.
As I said earlier, this isn't simple. It requires that you get an IRS "account transcript" and a similar item for your state taxing authority. Your bankruptcy attorney will examine the transcripts and tell you if it's likely that the taxes will be discharged in your bankruptcy.
Important Case Update!
The 11th Circuit (which covers Georgia, Alabama and Florida) has issued a new ruling that limits the Dischargeability of taxes when the returns are filed late.
While I have heard that the IRS is only enforcing this new ruling in certain cases, attorneys and clients must consider this ruling in helping to decide whether to file a chapter 7, Chapter 13, or no bankruptcy at all!
Bottom Line? ALWAYS file your taxes on time, even if you can not afford to pay!
Circuit Splits Widen on Dischargeability of Tax Debts on Late-Filed Returns
The Eleventh Circuit charted a different course from three other circuits in holding that the debt shown on a late-filed tax return is not dischargeable under Section 523(a)(1)(B)(i) and the so-called hanging paragraph added by Congress along with the 2005 amendments.
Three circuits — the First, Fifth and Tenth — ended up with what’s been called the one-day-late rule: If a return is filed even one day late, the underlying debt can never be discharged, employing a complicated application of case law, several federal statutes and the Bankruptcy Code. It has been said by commentators such as Prof. Ronald J. Mann from Columbia Law School that even the Internal Revenue Service will not support that interpretation.
In a March 30 decision by Circuit Judge R. Lanier Anderson, the Eleventh Circuit held a tax debt nondischargeable using a different theory.
In this case, the debtor did not file tax returns for the years 2000 through 2003. The IRS gave notice of deficiency and assessed taxes in 2006. The taxpayer filed tax returns for those years in 2007, followed by a chapter 7 petition in 2011. The bankruptcy judge held that the tax debt was nondischargeable, and the district court agreed on appeal.
Assuming without deciding that the one-day-late rule is wrong, Judge Anderson used a different approach that still kept the debtor on the hook for the tax debt.
Judge Anderson invoked the four-part test resulting from a 1984 Tax Court decision known as Beard. His opinion focused on the fourth Beard test: Was there an honest and reasonable attempt to satisfy the requirements of tax law?
On that question, there is a split of circuits. The Eleventh Circuit chose to follow the majority, which requires “analysis of the entire time frame relevant to the taxpayer’s actions.” A minority of one, the Eighth Circuit held that “honesty” should be determined exclusively from the face of the tax return. In a dissenting opinion in the Seventh Circuit, Circuit Judge Frank Easterbrook saw the law as the Eighth Circuit did.
In following the majority, Judge Anderson relied on the notion that our tax system depends upon “honest self-reporting.”
Although declining to adopt a per se rule, Judge Anderson held that there is no “honest and reasonable effort” to comply with tax law when the taxpayer files a return “years late, without any justification at all, and only after the IRS has issued notices of deficiency and has assessed his tax liability.”
The opinion does not hint as to whether a tax claim could be discharged if, for instance, the debtor filed a late return before the IRS levied an assessment. In that case, the Eleventh Circuit might have to decide whether three circuits made good or bad law with the one-day-late test.