Bankruptcy & Taxes
THE THREE RULES for Eliminating Income Taxes (Missouri and Federal)
Income tax debts can be discharged in bankruptcy. The tax debt can be discharged (eliminated) only if all of the following three requirements are met with respect to each tax year.
THREE YEAR RULE
More than 3 years must elapse between the bankruptcy filing date and the date the income tax return was last due, including all extensions.
Example: 2003 federal income taxes can not be discharged in bankruptcy unless the bankruptcy petition is filed on or after 4/16/2007.
Extensions: The 3 year time period does not expire until the due date for filing the tax return. For federal income taxes, if no extension is requested, the 3 year time period will elapse on April 15 of the 3rd year following the tax year in question. If an automatic extension is requested, the 3 year time period will not expire until the last date of the extension period which is generally August 15th .
Example: If the taxpayer requests a four month automatic extension to file his 2003 federal income tax return, the taxes can not be discharged in bankruptcy unless the bankruptcy is filed on or after August 16, 2007.
Due Date of Tax Return Controls - Not The Actual Date the Tax Return is Filed. The last due date for filing the tax return is the proper date for determining if the 3 year age rule has been satisfied. The date the taxpayer actually files the return is irrelevant for the three year rule.
Example: On April 15, 2004, Taxpayer requests an automatic extension to file his 2003 federal income tax return, which makes the return due on August 15, 2004. It is irrelevant to the 3 year age rule whether Taxpayer actually files the return early (prior to August 15, 2004) or late (after August 15, 2004). The taxes will be discharged only if the bankruptcy petition is filed on or after August 16, 2004.
TWO YEAR FILING RULE
To discharge a tax debt in a Chapter 7 case, the taxpayer must file the return for the tax year in question more than 2 years before he files for bankruptcy. Although the 3 year rule considers the age of the tax, the 2 year rule only deals with the filing of any required tax return.
IRS Filed Returns May Not Qualify. The Internal Revenue Code authorizes the IRS to file a substitute return for a taxpayer if he fails to prepare and file the return. If IRS prepares a return for the taxpayer, the taxpayer can consent to the return by signing it, or the IRS can file the return without the taxpayer’s consent. If the taxpayer does not sign or otherwise agree to an IRS filed return, the IRS return does not count as a filed tax return for purposes of the 2 year filing rule. However, if the taxpayer signs the return, the IRS return will count as a filed return for purposes of the 2 year filing rule.
The Filing Date for Purposes of 2 Year Rule. Federal tax returns filed before the due date are not considered filed until the due date. Returns filed after the due date are considered filed on the date the IRS actually receives the return. If the taxpayer files the return before the due date, the 2 year time period starts to run on the tax return due date, not the actual filing date. If the taxpayer files the return late (after the last due date), the 2 year time period starts to run on the date that IRS actually receives the return.
240 DAY ASSESSMENT RULE
A taxpayer can not discharge a tax in bankruptcy unless the taxing authority assesses the tax more than 240 days before the taxpayer files for bankruptcy. If the taxpayer makes any offer in compromise, the 240 day time period is extended or tolled by the number of days the offer in compromise is pending, plus an additional 30 days. The 240 day rule normally comes into play only if the taxing authority audits a prior return and assesses additional tax as a result of the audit.
Example: On April 15, 2004, Taxpayer files his 2003 federal income tax return. On November 1, 2006, IRS commences an audit of the 2003 return. On April 14, 2007, as a result of the audit, IRS assesses $100,000 of additional tax. Taxpayer has satisfied both the 3 year age and 2 year filing rules, but the 240 day assessment rule will not be satisfied until after December 11, 2007; 240 days after IRS assessed the additional tax. To discharge the $100,000 of additional tax, Taxpayer can not file bankruptcy until on or after December 11, 2007.
Tax Fraud and Willful Evasion. A tax debt is not dischargeable in a Chapter 7 bankruptcy case if the taxpayer files a fraudulent return. A return is fraudulent if the taxpayer intentionally fails to report income or makes misrepresentations on the return. Likewise, a taxpayer can not discharge a tax in a Chapter 7 bankruptcy case if he willfully attempts to defeat or evade payment of the tax. The following conduct could qualify as tax evasion: (1) the taxpayer has the ability to pay the tax but uses the funds for other purposes; or (2) the taxpayer evidences a pattern of failing to file returns, failing to pay taxes, or attempting to hide income and assets. The tax fraud issue can be raised after the bankruptcy case is filed and closed.
There are two parts to every employment tax: the employee portion and the employer portion.
Employee Portion (Trust Fund Taxes). The employee portion is the portion of the tax which the employer is required to withhold from an employee’s pay check and remit to IRS. The employee portion includes the federal withholding tax, social security tax and Medicare tax. The employee portion is typically referred to as a "trust fund" tax because the employer is required to hold the money in trust, on behalf of the employee, for payment to IRS.
Trust fund tax is never dischargeable in bankruptcy, regardless of the age of the tax. Even trust fund taxes which are over 10 years old can not be discharged in bankruptcy. However, see the discussion below “Statute of Limitations" for a discussion of the 10 year time limit on the collection of federal tax debts.
Employer Portion. The employer portion is the tax which the employer owes directly to the government. The employer portion includes the employer’s obligation to pay an additional percentage of social security tax and an additional percentage of Medicare tax.
A taxpayer can discharge the employer portion if:
(a) more than 3 years pass between the bankruptcy filing date and the date the 941 tax return is last due, including all extensions;
(b) more than 2 years elapse between the date the 941 tax return was filed and the date the bankruptcy is filed; and
(c) the taxpayer did not willfully evade payment of the tax.
There is no 240 day assessment rule for employment taxes. If the 3 year, 2 year and tax evasion rules are all satisfied, it is irrelevant when IRS assesses the tax.
Sales tax is a tax collected from a customer by a seller of goods or services.
Trust Fund Status of Sales Taxes. In Missouri, sales taxes are classified as "trust fund" taxes and are not dischargeable in bankruptcy, regardless of the age of the tax. The taxes are "trust fund" taxes because the employer is obligated to collect the tax from the customer and hold the funds in trust for payment to the Missouri Department of Revenue.
PENALTIES AND INTEREST
Interest. For federal tax debts, the interest follows the tax. If the tax is dischargeable in bankruptcy, the interest is dischargeable. If the tax is not dischargeable, the interest is likewise not dischargeable.
Tax Dischargeable - Penalty Dischargeable. If a federal tax is dischargeable in bankruptcy, the penalty is also dischargeable.
Non-Dischargeable Taxes. The reverse of the previous rule is not necessarily true. In some cases, the penalties related to non-dischargeable taxes are likewise not dischargeable. However, in other cases, the penalty is dischargeable even if the underlying tax is not dischargeable.
- (a) Non-Dischargeable Taxes Less than 3 Years Old. If the tax is not dischargeable because it relates to a tax year less than 3 years old, any penalty relating to the unpaid tax will also be non-dischargeable.
- (b) Non-Dischargeable Taxes More than 3 Years Old. Tax penalties are dischargeable in bankruptcy if the events giving rise to the penalty occurred more than 3 years before the taxpayer files for bankruptcy, even if the related tax is not dischargeable.
OFFERS IN COMPROMISE
An offer in compromise is an alternative method of settling a tax debt by offering to pay IRS less than the full amount due. It is a non-bankruptcy remedy. The submission of an offer in compromise will toll the running of (stop the clock on) the 240 assessment time period. If the taxpayer makes an offer in compromise within 240 days of filing for bankruptcy, the 240 day time period will be suspended for the time during which the offer in compromise is pending, plus an additional 30 days.
Tax debts can become "secured" debts if the taxing authority takes the steps necessary to obtain a lien against the taxpayer’s property before he files for bankruptcy. If the taxing authority obtains a pre-bankruptcy tax lien, the attachment of the lien can drastically impair a taxpayer’s ability to avoid payment of the tax through a bankruptcy filing.
Federal Tax Liens - Attachment of Lien. To obtain a federal tax lien valid in bankruptcy, IRS must file a "Notice of Federal Tax Lien" in the real property records of the county clerk before the taxpayer files for bankruptcy.
Real Property (Land & Improvements). To assert a valid tax lien against real property (land and improvements to land), IRS must file the tax lien notice in the county where the land is located.
To assert a valid tax lien against personal property (everything other than land and improvements to land), IRS must file the tax lien notice in the county where the taxpayer resides on the date the tax lien notice is filed. It is irrelevant whether the property is located in a county different from the taxpayer’s residence or whether the taxpayer moves to a different county after IRS files the tax lien notice. If the tax lien is properly secured, the taxpayer can not defeat the lien by moving his residence or property to a different county.
Pre-Bankruptcy Liens Survive Bankruptcy. A tax lien will continue to exist after the entry of a bankruptcy discharge with respect to all property the taxpayer owns on the date he files for bankruptcy. Although the tax lien survives bankruptcy, the taxpayer’s personal liability to pay the tax will be released if all other requirements for a bankruptcy discharge are satisfied. This means that after the entry of a discharge order, the taxing authority can never collect the tax as a personal obligation of the taxpayer, but can pursue collection by seizing and selling any property the taxpayer owned on the date he filed for bankruptcy.
Tax Liens Do Not Attach to Post Petition Property. Tax liens do not attach to property acquired by a taxpayer after he files for bankruptcy, unless he acquires the property with funds or property he owned before filing for bankruptcy. In other words, if the tax debt is dischargeable, and the taxpayer acquires any property after he files bankruptcy, with funds earned after the bankruptcy filing, the taxing authority will not be able to seize and sell the post petition property to pay the tax. For this reason, a tax lien will not affect a taxpayer with few assets on the day he files for bankruptcy.
STATUTE OF LIMITATION
IRS’s ability to collect any federal tax expires 10 years after it assesses the tax, unless it commences a lawsuit to collect the tax, obtains a favorable court judgment and periodically renews the judgment. The 10 year statute of limitations also applies to tax liens. A federal tax lien will expire 10 years after the tax is assessed, unless IRS begins a lawsuit to collect the tax, obtains a favorable court judgment, and periodically renews the judgment. The 10 year time period begins to run on the date IRS assesses the tax, not on the date it files a tax lien. A bankruptcy filing is unnecessary if the taxpayer’s primary goal is to avoid payment of a federal tax assessed more than 10 years ago.
Example: Taxpayer owes unpaid employment taxes (both the employer and employee portions) for the 1996 tax year. The unpaid tax was assessed on 1/15/1997. IRS files a tax lien five years later on 1/15/2001. Taxpayer can never discharge the employee portion of the tax in bankruptcy. However, the tax will become uncollectible, and the tax lien will expire, unless IRS files suit to collect the tax on or before 1/15/2007, 10 years after the tax was assessed.
Chapter 13 Cases. The rules relating to discharge-ability of tax debts are more liberal in Chapter 13 cases than Chapter 7 cases. Tax claims (as well as all other debts) are classified as secured, priority or general unsecured debts. The classification of a debt as secured, priority or general unsecured will usually determine whether the taxpayer must pay all or none of the tax, and whether interest and/or penalty must be paid.
Priority Taxes. A Chapter 13 repayment plan must propose full payment of all "priority" debts. The bankruptcy court will not approve a plan that does not meet these guidelines. A "priority" tax is any income, employment, sales or property tax which can not be discharged in a Chapter 7 case, except for two very important differences as follows:
Two Tear Rule Not Applicable. The two year filing rule does not apply in Chapter 13 cases. For income tax debts, the tax will be classified as "general unsecured" rather than "priority," and can be discharged without payment, even if the taxpayer never files a tax return, so long as the 3 year age and 240 day assessment rules are satisfied.
For employment taxes, the employer portion will not be classified as "priority," and can be discharged without payment, if the tax satisfies the 3 year age rule. A taxpayer’s failure to file a 941 tax return will not prevent discharge of the tax.
Chapter 7: The taxpayer never filed any federal income tax returns for the 1996 through 2006 tax years. Taxpayer can never discharge any of these taxes in a Chapter 7 case. It does not matter when the case is filed. A tax can never be discharged in a Chapter 7 case if Taxpayer never files a tax return.
Chapter 13: If Taxpayer files a Chapter 13 case on or after April 16, 2007, the 1996 through 2003 taxes will be classified as "general unsecured" and can be discharged without payment if Taxpayer successfully completes a Chapter 13 plan ( assuming it is a plan in which the unsecured creditors do not get paid). The 2004 through 2006 taxes will be classified as "priority" taxes and the Chapter 13 plan must provide for full payment of these taxes.
Tax Evasion Limitations Not Applicable in Chapter 13. The rules preventing discharge of taxes resulting from willful evasion or a fraudulent return do not apply in Chapter 13 cases. In Chapter 13, the taxpayer can discharge the tax without payment, even if he is guilty of tax evasion or filed a fraudulent return. However, the government can still criminally prosecute the taxpayer for tax evasion, even after the taxes have been in Chapter 13, so long as the 6 year statute of limitation for tax fraud prosecutions has not expired.
Interest and Penalty on Priority Tax Claims. A priority tax claim includes all accrued interest though the bankruptcy filing date, but excludes all accrued penalties. The Chapter 13 plan will not pay post filing interest on any priority claim, including priority tax claims.