Discharging Taxes Through Bankruptcy
If you owe past due income taxes that you cannot pay, bankruptcy may be an option. There is a common misconception that past taxes cannot be discharged in bankruptcy. This belief is simply untrue. It is possible to discharge income tax debt in bankruptcy, if your tax debt fits within certain requirements.
A bankruptcy discharge releases the debtor from personal liability for certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order of the court prohibiting creditors of the debtor from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contacts.
For individuals there are three types of bankruptcy: Chapter 7, Chapter 11, and Chapter 13. At very high level the differences between the bankruptcy types determines the period of time the courts will be involved in the process and how long the creditors are held at bay from resuming collections.
When a bankruptcy is filed ALL assets and debts are required to be disclosed. Certain assets/debts are excludable by law, others may be exempt as determined individually by the courts.
What Cannot Be Discharged
- Certain taxes
- Spousal or child support and corresponding attorney fees
- Debts to government agencies for fines and penalties not income tax related
- Student loans (exceptions apply)
- Personal injury judgments caused by the debtor’s operation of a motor vehicle while intoxicated
- Debts owed to certain tax-advantaged retirement plans
- Debts for certain condominium or homeowners association fees
- Court fines and penalties, including criminal restitution
- Debts not disclosed when bankruptcy is filed (exceptions apply)
A creditor can petition the court to allow a debt to survive bankruptcy. The court will generally honor the motion if it can be shown the intent of the debtor was to defraud the creditor.
Certain taxes are not dischargeable in bankruptcy. Specifically tax liens are not discharged. An example of a tax lien would be property taxes. A tax lien is an obligation of the property, not the property owner. Bankruptcy will relieve the owner from collection of the debt but it will not prohibit the taxing authority from forcing the sale of the property to satisfy the tax lien of the property.
Other taxes such as employment taxes on payroll, sales tax, tobacco tax, excise taxes, etc. will survive a bankruptcy.
The bankruptcy code permits the discharge of income tax in certain circumstances. The tax debts must be known and fixed. If the statutes still allow either party to modify the obligation the debt is not fixed and therefore cannot be discharged.
The criteria for discharging tax debt
The debt must be income based which means it is the tax based on items included on your federal personal income tax return and your personal state income tax return.
Due At Least Three Years Ago
The taxes must become due at least three years prior to the date the bankruptcy is filed. As an example, your personal income tax return for 2012 was due on April 15, 2013. With an automatic extension the tax due date would be October 15, 2013. If the tax return was timely filed on or before October 15, 2013, any unpaid tax as of October 16, 2016 could be discharged in bankruptcy
Filed Two Years Ago
In addition to the tax being due at least three years ago, the tax return must have actually been filed at least two years ago. If you filed your 2010 income tax returns (originally due on April 15, 2011) on August 8, 2015, you would need to wait until August 9, 2017 to have those taxes discharged in bankruptcy.
Two Hundred and Forty Days
The agency must have assessed the tax against you at least 240 days prior to filing. As a practical matter, the taxes are assessed on the day you file your return. However, if the agency examines the tax return and makes adjustments you should wait 240 days before filing.
Example: Tom Smith files his properly extended 2012 tax return on October 15, 2013. Under normal circumstances those taxes would be eligible for bankruptcy discharge on October 16, 2016. However, the IRS choses to examine the tax return on October 15, 2015. The audit process was time consuming with some back and forth document gathering and the audit does not formally close until February 29, 2016. The audit assesses additional tax. The unpaid portion of the entire adjusted tax liability will be eligible for bankruptcy discharge on October 26, 2016 which is 240 days past February 29, 2016.
Get Those Returns Filed
There are two significant reasons to file all past due tax returns. You want to start the clocks on the statutes of limitations for assessing additional tax and collecting the tax.
Two Year Limit
The IRS has two years from the date of filing, or three years from the due date of the return whichever is later to assess additional tax. Once those windows have closed neither party can make adjustments to the return.
Ten Year Limit
The IRS has ten years from the date tax is assessed to complete the collection process.
Example: Tom Smith files his properly extended 2012 tax return on October 15, 2013. The IRS is unable to continue collection action on that debt past October 15, 2026. The taxpayer may make voluntary payments on this debt after that time.
There are exceptions to the ten-year rule, bankruptcy being one of them. The IRS will place the collection process on hold while the bankruptcy is active. This could be several years. The ability to collect the debt is extended by the amount of time the IRS is not allowed to pursue the collection.
Four Tax Return Requirement
Certain types of bankruptcy require the taxpayer be current with tax filing for the prior four years. Chapter 13 Bankruptcies will place the taxpayer on a payment plan for three or five years. Under Chapter 13, the courts will require all tax returns to be filed that would have been due within four years of the date of filing. The tax returns are filed so the amounts due can be included in the payment plan of the bankruptcy.
As a reminder back taxes filed as part of the bankruptcy process are not eligible to be discharged as they will not meet the three year, two year, and 240 day requirements for discharge.
Under a Chapter 7 Bankruptcy (a complete liquidation) the court may not require the back tax returns to be filed as there is no payment plan.
Generally, persons considering bankruptcy have multiple financial issues so they do not file taxes as it will simply add more to their debt load. These taxes will survive the bankruptcy and still be due and collectible. There are a few options available to those with back tax debt.
Under current guidelines the IRS will permit a taxpayer to enter into an installment agreement with a six-year payment term for debts totaling less than $50,000. This type of installment agreement is automatic.
If your debt is more than $50,000 or you are unable to afford the six-year monthly payment term, you can complete a financial statement and the IRS will determine what your payment will be using published living allowances for your zip code. The standards are based on poverty levels and family size. In determining your monthly payment, the IRS is attempting to ensure you live within your means.
The IRS Is Human Too
The IRS is not looking to make you sell all your stuff and live on a park bench or under a bridge. A poverty standard for your family size may dictate an allowable rent of $400 per month, however, if you earn $60,000 per year, they may not deem a $4,000 per month mortgage payment unreasonable. If your actual housing expense is $6,000 per month they will not make you move out, however, they may only allow a smaller number (say $4,300) to be allocated to housing based on your income. The implication here is that you may wish to consider more affordable housing based on your income.
The IRS will allow expenses for any ongoing medical treatment. The current costs of treating disease, therapy, or prescription medications are taken at face value and area not discounted. They are expenses allowable in full regardless of income.
Debts Not Allowed In Payment Plan
If you do not use the installment agreement option and the IRS is determining your payment based on financial information you provide they will not consider other debts you have such as credit cards and car payments.
In polite terms, the IRS is simply another debt you have. You haven’t paid them in quite some time. They view it as it is time to pay them and let the other folks wait for a while and give the IRS a turn. In legal terms, the IRS is exercising their muscle under the laws of the land as a priority creditor that is to be paid first before any other obligation.
If you are working and bringing in a modest income the IRS will work with you to determine a payment plan amount. This amount may still be regarded as financially stressful. The exact qualifications to be eligible for uncollectable status are not published so no specific guidelines are available.
When your income falls below these levels the IRS will deem the debt as currently not collectible. You still owe the debt but the IRS will make no effort to collect it. The letters will stop until such a time as the IRS notices your income has increased. At that time, you will begin to receive notices and you will have to requalify for a payment plan of some kind.
Offer In Compromise
An offer in compromise allows you to settle your tax debt for less than the full amount you owe. It may be a legitimate option if you can’t pay your full tax liability, or doing so creates a financial hardship. The IRS will consider your unique set of facts and circumstances such as:
- Ability to pay
- Income (ability to earn)
- Asset equity
The IRS will generally approve an offer in compromise when the amount offered represents the most they can expect to collect within a reasonable period of time.
You are not eligible for an offer in compromise if you are not current with your tax filings or you have an active bankruptcy in process.
Offers in compromise are evaluated on an individual basis. As a general guide you must offer the IRS at least as much money as they could get if they went to court and garnished your wages for about three years. The maximum amount of garnishment is 25% of your income after taxes but not below what you would take home making minimum wage. Example: If the IRS could garnish your wages and receive $500 per month, your offer would need to be at least $18,000 regardless of the amount of debt owed.
The exact guidelines for accepting an offer in compromise are not publicly available. The IRS’s willingness to accept an offer in compromise is based more on their belief in your ability to generate future income than a current lump sum payment due to a windfall in income such as a gift.
In most circumstances the IRS requires a payment of a portion of your offer when you submit the offer in compromise. The system has checks and balances in place to prohibit the IRS from cashing the check that comes in with the offer and then denying the offer just to collect the deposit money.
Downside of Offer In Compromise
Processing all the paperwork for an offer in compromise is just the tip of the iceberg. The IRS will want copious amounts of information– pay stubs, bank records, vehicle registrations, grocery receipts, medical bills just to name a few.
Given the amount of work involved it does not make sense to submit an offer unless you believe it will be accepted. Another drawback to submitting an offer is that the information you provide gives the IRS a complete list of all your assets and may help them to accelerate their collection efforts against you.