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Taxes and Bankruptcy & How They Mix

It’s not completely true that the only things you have to do in life is die and pay taxes. Well, I guess the dying part is sort of inevitable. My bankruptcy clients ask if they can get rid of taxes as part of their bankruptcy filing.

Income Taxes and Bankruptcy. Are they Dischargeable?

You may be able to discharge or get rid of relatively old income taxes in Bankruptcy if the following four conditions are met:

1.  Legitimate Return Filed:  You must have filed a legitimate (non-fraudulent) tax return for the tax year in question.

    • A Substitute for Return completed by the IRS that you don’t sign or consent to does not satisfy this requirement.

2.  Actual File Date 2 Years Before Bankruptcy Filing:  The liability you wish to get rid of is for a tax return (again, not a Substitute for Return) that you actually filed at least 2 years before filing Bankruptcy.

3.  Taxes you wish to discharge were due at least 3 years before you filed for Bankruptcy:   The tax return for the liability that you wish to get rid of was due at least 3 years before filing for Bankruptcy.

4.  No Assessment by IRS within 240 Days of Filing for Bankruptcy:  You cannot be assessed by the IRS for the taxes in question within 240 days before filing for Bankruptcy.

  • Example:  Kelly files a tax return on August 1, 2001, for the 2000 tax year. In April 2003, the IRS audits Kelly’s 2000 tax return and assesses a tax due of  $15,000. Kelly files for Bankruptcy on June 1, 2004 in hopes of getting rid of the tax debt.  Kelly actually filed the tax return for tax year 2000 on August 1, 2001, more than 2 years prior to her Bankruptcy filing date (June 2004).  The tax return for the year 2000 was due on April 15, 2001, more than 3 years prior  to Kelly’s Bankruptcy filing date June 2004. The assessment by the IRS was conducted in April 2003, which was more than 240 days before Kelly’s filing date in June 2004.  So in this taxes and bankruptcy scenario, Kelly can get rid of her 2000 income tax debt.

Are There Penalties?

Now, that we’ve covered how income taxes and bankruptcy works, let’s address potential penalties.

  • You can get rid of penalties on back taxes if the underlying tax debt is dischargeable.  The general rule of thumb is that penalties on taxes that are dischargeable (meet the four requirements discussed above) are also dischargeable.
  • You may not be able to get rid of penalties on back taxes if the underlying tax debt is not dischargeable. Courts are split about whether you can discharge penalties on back taxes if the underlying debt is not dischargeable.

Let’s use Brynn as an example.

Brynn failed to file a tax return for 1997. Vigilent Vera of the IRS discovers Brynn’s failure in 2002 and in January 2003 assesses a tax of $7,000 and penalties and interest of $13,000. Brynn files Bankruptcy in January 2004. Since Brynn did not file a tax return for 1997, she cannot get rid of the underlying tax debt ($7,000) in Bankruptcy as filing a legitimate tax return for the tax year in question is one of the requirements to discharging the underlying tax debt.  This holds true even though the other requirements for discharge ability of the taxes are met in that the tax debt was due (April 15, 1998) more than 3 years before Brynn filed for Bankruptcy (January 2004) and more than 240 days elapsed since the IRS made its assessment (January 2003). While Brynn is precluded from discharging the tax debt for failure to file a tax return and/or pay the tax debt, she may be able to get rid of the penalties ($13,000).

Recent California court decisions, however, show that Brynn likely faces an uphill battle.  There is no clear cut rule here as Courts are split.  Brynn has the affirmative duty to raise the dischargeability of her penalties issue – she will likely face opposition from the IRS, however. It is best to leave these technical issues, especially those related to taxes and bankruptcy, up to attorneys familiar with recent local courts decisions.

About Sean Hanley

Practicing law since 2007, Sean specializes in the ever-changing laws related to real estate, business and estate planning. Embracing technology with a focus on personalized service, he understands the challenges of living and thriving in Silicon Valley. Tapping into his education in economics and business administration, Sean also serves on the non-profit Willow Glen Business Association.

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