TAXES: Are they dischargeable in bankruptcy?

TAXES:  Are they dischargeable in bankruptcy?

Published on July 21, 2012 by: Ian M. Falcone

Often, I am asked whether tax debts are dischargeable in bankruptcy.  The short answer, as almost always is the case, is, it depends.  In order to make a determination, we need to know whether we are talking about trust taxes or income taxes.

Trust taxes are those taxes collected on behalf of a another party.  The two most common examples are sales taxes and payroll withholding taxes.  When you pay for an item in the store, you pay sales tax at the cash register.  The business is collecting the tax from you and holding it in trust to pay the taxing authority. 

Withholding taxes are the taxes that an employer withholds from your paycheck. It is important to note that there are actually two components to ­­­payroll taxes.  There is the portion the employer withholds and an equal payment that is matched by the employer.  Only the portion withheld from the employee’s paycheck is a trust taxes.

The person responsible for paying the taxes and failing to do so is personally responsible for the debt.  In a very small business, this is typically the owners.  In a larger business, it can be the treasurer, CFO or someone with similar duties.

Trust taxes are unfortunately, never dischargeable.  Income taxes, however, can be.

Income taxes follow a very convoluted rule.  They must be taxes that became due more than three (3) years prior to the filing of the bankruptcy petition, an actual tax return must have been filed more than two years prior to the filing of the petition, and they must have been assessed more than 240 days prior to the petition date.

The 3-year rule works as follows:  first, determine which tax year is at issue.  Second determine what date those taxes were due, including extensions.  Third, look at a calendar for the current date.  So, if the taxes were due for the 2008 tax year and no extensions were filed and it is July 21, 2012, the taxes would meet the 3-year rule.  To say it another way, as you sit there on July 21, 2012, those taxes were due on April 15, 2009 (2008 taxes are due in 2009) which is more than 3 years prior to the filing date.  However, if you asked the same question on April 14, 2012, those taxes did not meet the 3 year rule.  As you can imagine, filing an extension changes the due date and the calculation become that much more difficult.

Assuming the taxes meet the first prong of the test, we next turn to whether the return was filed more than two years ago.  Under old law, the IRS could file a return for you (known as a “substitution for return’) and you could calculate time using that date.  Under recent law, the debtor must have filed an actual return at least two years prior to the date of the bankruptcy petition.  If the tax return was never filed, the two year period never starts to run.  So, returning to the above example, if the debtor never filed the return, meeting the 3-year portion of the test doesn’t help, because the second prong can never be met.  But, what if the debtor filed his return on July 10, 2010?  Here he meets both the first and second prong of the test.  The return was due more than 3 years prior to the bankruptcy filing and an actual return was filed more than 2 years ago.

Finally, if both the 3-year and 2-year prongs are met, we next turn to whether the taxes were “assessed” more than 240 days prior to filing the petition.  “Assessed” is a term at the IRS meaning the date it is entered in their system.  It is not the date the tax return was filed.  The only way to truly determine the assessment date is to contact the IRS and obtain a tax transcript with that information.  Audits, challenges, offers in compromise and other actions can extend the date of assessment.

Finally, as a general rule, if the underlying tax is not dischargeable, then the associated penalties and interest are not dischargeable either,  However, this is only a basic rule.  Further, if a tax lien has been filed, a new layer of complexity is added, but that is for another day.

As you can see, these rules are complicated and not as easy to understand as one might hope.  If you have tax debt and want to try and discharge it, you should discuss the matter with a more experienced bankruptcy attorney that has familiarity with business and tax issues.