Every single year, about seven million Americans fail to file their federal income tax returns. That’s about five percent of the adult population of the United States. Millions more are delinquent on their federal income taxes, some going back for years.
At the same time, over one million individuals and businesses file for some form of bankruptcy protection each and every year. Obviously many tax delinquencies are associated with people who are struggling financially and might benefit from the protections of a bankruptcy filing.
So the question naturally arises: if, when, and to what extent can unpaid taxes – federal, state and local – be discharged or managed in bankruptcy?
Different Forms of Bankruptcy
Preliminary, it is important to have a basic understanding of the different forms of bankruptcy and bankruptcy protection, as each impacts your tax debt differently. Chapter 7 or “straight bankruptcy" discharges all debts except those that are deemed “exempt" under the federal Bankruptcy law.
By contrast, a bankruptcy petition filed under Chapter 13 reorganizes your debts by allowing you, the debtor, to pay them off through an approved “reorganization" plan. Typically the plan lasts three to five years, and is administered or managed by the bankruptcy trustee.
At the end of that time period, any of your remaining debt is wiped clean just like a straight bankruptcy.
Can Unpaid Taxes Be Avoided or Abolished in Bankruptcy?
A common belief by those who do not work regularly in the bankruptcy field is that taxes cannot be cleared off and wiped clean in a bankruptcy proceeding. This notion is incorrect. The correct answer to the question is: yes. Federal, state and local taxes can, sometimes, be abolished by a bankruptcy filing.
A Chapter 7 or so-called “straight bankruptcy" can wipe clean and abolish past due federal income taxes provided you meet certain requirements which we will cover below. Other types of federal taxes, such as payroll taxes or fraud penalties, cannot be erased by bankruptcy. Put another way, they survive bankruptcy even if your federal income taxes do not.
Which Back Taxes Can Be Discharged or Managed in a Bankruptcy?
Which of your back income taxes can be avoided, and to what extent, is a complicated question, turning on a host of considerations. But if you fit within certain rules, you may have struck pay dirt.
In short, for taxes to be dischargeable they cannot be new. This is because the rules determining which taxes can be wiped clean in bankruptcy involve strict time frames. In this connection, there are three rules: the three-year rule, the two-year rule, and the 240-day rule. Collectively, people working in the bankruptcy field often call them the “3-2-240 rules."
The three-year rule sets an initial benchmark. Your taxes must be past due and unpaid by at least three years in order to them to qualify for discharge consideration. For example, you cannot discharge last year’s taxes, no matter how burdensome or impossible it is for you to pay them.
The two-year rule pertains to filing. No matter how long you have owed past taxes, you can only discharge those that are unpaid for tax returns filed at least two years ago. So, if you failed to file your federal income tax return of five years ago until just now, even if a substantial amount is now owing under that return, you must still wait at least two years after your current filing to avoid those taxes in a bankruptcy.
The 240-day rule applies to the IRS assessment time frame. Taxes only assessed (or imposed) by the IRS in the 240 days preceding the filing of your bankruptcy petition do not qualify for bankruptcy protection. The taxes must have been fixed and imposed (“assessed") by the IRS 240 days ago or longer in order to be reachable by the bankruptcy court.
A quirk to the above rules is that the running of these time frames are deemed frozen – or suspended – pending the occurrence of certain events. Such events include any time frame when the IRS is reviewing and taking under consideration any Offer in Compromise you may have applied for, or any time period during which you filed a prior bankruptcy petition, or any time when you were officially pursuing a “taxpayer assistance order." When any such event ceases, the time period starts to run again. In the vernacular of the IRS, this is called “tolling" the minimal time requirements.
How Do You Know If You Have Met and Satisfied the “3-2-240 rule"?
Taxes are never easy. The official dates of when the taxes were due, when a filing occurred and when an assessment was made by the IRS are not precisely spelled out in the letters or forms the Service may have sent to you.
The best and most accurate way to ascertain if you have met and satisfied the relevant time frames is to ask the IRS for a so-called “account transcript" or “literal transcript." You will need one such transcript for each year of taxes you are hoping to avoid. This document will identify in one place all the official dates you need.
You can order these documents by year by accessing the IRS official website for such info, at irs.gov/Individuals/Order-a-Transcript. Alternatively, you can call the toll-free number, at 800-908-9946. And if you prefer, you can use IRS Form 4506T and simply drop it in the mailbox.
A final technical note: Do not order a “tax return transcript" to obtain the information you need. That is a different document altogether. You must be precise in requesting an “account transcript." The devil, for sure, is in the details.
Can A Bankruptcy Reach Interest and Penalties Due on Unpaid Taxes?
Yes, a bankruptcy can reach interest and penalties due on unpaid taxes. Generally speaking, the rules in this area make no distinction between the past due taxes portion and the interest and penalties portion. In other words, if the underlying taxes are dischargeable, so too are the related interest and penalties.
In conclusion, needless to say, the intricacies of bankruptcy virtually demand retention of a qualified debtor-creditor, CPA or bankruptcy attorney who can lay out your options and present your claims and exemptions. Navigating these waters without one would likely be a perilous voyage.
The Bankruptcy Reform Act of 1978, amended, Title 11 of the United States Code.
Bankruptcy Fact Check: snopes.com/643000-bankruptcies-in-the-u-s-every-year-due-to-medical-bills/
Bankruptcy Lawyer: bankruptcylawyerpa.com/blog/income-taxes-are-dischargable-in-bankruptcy/
Kinds of Bankruptcy: ms-bankruptcy.com/bankruptcy-info/differences