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The Four Conditions for Writing Off Income Taxes in Bankruptcy

The conditions for writing off income tax debts actually make sense.

 

The last blog introduced the four conditions for discharging (legally writing off) taxes in bankruptcy. Here’s a fuller explanation of them.

The Core Principle Behind the Four Conditions

There is a simple principle behind all four of these conditions: under bankruptcy law taxpayers should be able to write off their tax debts just like the rest of their debts, AFTER the IRS (or other tax authority) has a reasonable length of time to try to collect those taxes.

What’s a reasonable length of time in the eyes of the law? How much of an opportunity do the tax authorities have to collect before you can discharge the tax debt?

The four conditions each measure this amount of time differently, based on the following:

1) when the tax return for the particular income tax was due,

2) when the tax return was actually filed,

3) when the tax was “assessed,” and

4) whether the tax return that was filed was honest and therefore reflected the right amount of tax debt when it was filed.

To discharge an income tax debt, it must meet all four of these conditions.

Here they are in order:

1) Three Years Since Tax Return Due:

All income taxes have a fixed due date for its return to be filed. That date may be delayed by a certain number of months if you asked for an extension, but it’s still a specific point in time. This first condition gives the tax authorities three years from the tax return filing date, or from the extended filing date if you asked for an extension. Note that this is fixed date, not affected by when you actually filed the return nor by what the tax authority did once it received the tax return.

2) Two Years Since Tax Return Actually Filed:

This second condition is different than the first because it is a time period triggered by your own action, your filing of the tax return.

Note that you can file a tax return late and still be able to discharge the debt if at least two years have passed since you filed the return. (Caution: there are some parts of the country where some court opinions have questioned this—be sure to talk with your attorney about the law in your jurisdiction.)

3) 240 Days Since Assessment:

This third condition can be a bit confusing. It very seldom comes into play—most tax debts meet this condition without any problem.

Assessment is the tax authority’s formal determination of your tax liability. It usually happens in a straightforward way, when it receives, processes, and accepts your tax return.

Most of the time an income tax is assessed within a few days or weeks that it is received. So the period of time of 240 days after assessment usually passes long before the above three-years-since-the-return-is-due or two-year-since-tax-return-filed time periods. But the law has to account for the less common situations when the assessment is delayed. These situations can involve a lengthy audit, or litigation, or an “offer-in-compromise” (a taxpayer’s formal offer to settle). In these kinds of situations the three-year and two-year periods may have passed before the official assessment of the tax, and so the tax authority still has 240 days once assessment is made to pursue that tax debt.

4) Fraudulent tax returns and tax evasion:

This last condition effectively means that the above time periods are not triggered at all if you are intentionally dishonest on your tax return or try to avoid paying the tax in some other way. In those situations the tax authority has no opportunity even to begin collecting the tax. So, if you don’t meet this condition, you cannot discharge the tax no matter how old it is.

If your tax debt meets these four hoops, you should be able to discharge that tax in either a Chapter 7 or Chapter 13 bankruptcy.

If You Don’t Meet These Conditions

But what if you owe taxes which do not meet these four conditions, and so can’t be discharged? What if some of your taxes can be discharged by meeting these conditions but some of them don’t? Or what if the IRS or the state tax authority has recorded a tax lien? What if your tax debt arises from your operation of a business? What if you owe not income taxes but some other type of tax? The next few blog posts will get into these questions. 

 

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You Can Write Off Some Income Taxes with a “Straight Bankruptcy”

Chapter 13 can be a great way to deal with tax debts. But you don’t always need it, or its 3-to-5-year payment plan.

 

Chapter 7 vs. 13 for Income Taxes

Thinking that the only way to handle your income tax debts in bankruptcy is through Chapter 13 is a misunderstanding of the law. It’s an angle on the broader error thinking that you can’t write off taxes in a bankruptcy.

Both are understandable mistakes.

It is true that some taxes cannot be discharged (legally written off) in bankruptcy. But some can be.

And it is true that Chapter 13 can be the best way to solve many income tax problems. But that does not necessarily mean it is the best for you. Chapter 7 might be instead.

When Chapter 13 Is Better

Chapter 13 tends to be the better option if you owe a string of income tax debts, and especially if some are relatively recent ones. That’s because in these situations Chapter 13 solves two huge problems in one package.

First, if you owe recent income taxes which cannot be discharged, you get lots of advantages under Chapter 13, including paying less by avoiding most penalties and interest. That can be a huge savings, especially if you can afford only relatively small payments. Indeed the amount you pay each month is based on what you can afford to pay. You can often even hold off on paying anything towards the back taxes while you first pay even more important debts—such as back child support, or home mortgage arrearage.

Second, if you have older back taxes, under Chapter 13 you pay these only to the extent that you can afford to do so after first paying your more recent taxes. Then whatever of these older taxes are not paid during your case are discharged at the end of it.

When Chapter 7 is Better

But you don’t need the Chapter 13 package if all or most of your income tax debts are dischargeable. In that situation, the generally much simpler Chapter 7 could be enough.

So, what makes an income tax debt dischargeable under Chapter 7?

The Conditions for Discharging Income Taxes

Some of the conditions for determining which taxes can be discharged are quite straightforward, but some are more complicated. It’s not as simple as applying a simple formula to any particular tax debt to see if it is dischargeable. Figuring out whether a particular tax debt will be discharged requires the careful judgment of an experienced attorney.

The conditions for discharging income taxes are listed here, and then will be explained in the next blog. As listed, they may well not make perfect sense, so make sure you see the next blog post.

To discharge an income tax debt in a Chapter 7 case, it must meet these conditions:

1) 3 years since tax return due: The tax return for the pertinent tax must have been due more than three years before you file your Chapter 7 case. Also, if you requested any extensions for filing the applicable tax returns, add that extra time to this three-year period.

2) 2 years since tax return actually filed: Regardless when the tax return was due, you must have filed at least two years before your bankruptcy is filed in court.

3) 240 days since “assessment”: The taxing authority must have assessed the tax more than 240 days before the bankruptcy filing.

4) Fraudulent tax returns and tax evasion: You cannot file a “fraudulent return” or “willfully attempt in any manner to evade or defeat such tax.”

These four conditions need clarification, which will be provided in the next blog post.

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