Discharging Taxes in a Chapter 7 Bankruptcy

Taxes owed to the IRS the State of Ohio and municipal taxes to the City of Columbus and other surrounding central Ohio municipalities can be discharged in a chapter 7 bankruptcy. The legal basis under which taxes can be discharged in bankruptcy is derived from reading several sections of the bankruptcy code together. These include sections 523(a)(1) and section 507(a)(8) as well as a substantial number of court decisions interpreting these bankruptcy code sections. The wording of these sections is quite technical and can be difficult for the layman to both read and understand. However the rules for discharging taxes in bankruptcy can be understood and summarized as follows.

The rules for discharging taxes in chapter 7 bankruptcy apply equally to all taxing authorities, including the IRS and state and local governments.

Both income and employment taxes can be discharged in a chapter 7 bankruptcy along with the accumulated penalties and interest. Employment taxes should not be confused with "trust fund taxes" or withholding taxes that an employer is required to deduct from an employee's paycheck and remit to the taxing authority. Employment taxes are taxes on the employer or the matching portion of the “trust fund tax”.

To be eligible to be discharged in bankruptcy, first, the tax itself cannot be the subject of a tax lien. The tax must be “unsecured”, meaning the taxing authority has not filed a notice of lien.

Second, the tax owed must be for a tax year ending more than three years prior to the filing of the bankruptcy, computed from the date the tax return should have been filed (including extensions) to the date of the filing of the bankruptcy. For example it tax return for taxes owed for 2010 is due by April 15, 2011 any bankruptcy filed before April 16, 2014 will not discharge this tax. In addition if an extension for filing the tax return was obtained the additional time for the extension must be added to this calculation.

Third, the tax return itself must have been filed at least two years prior to the filing of the bankruptcy. Courts have interpreted this rule to mean the date the IRS actually assessed the tax and not to date the taxpayer put the tax return in the mailbox. The assessment date can only be obtained from reviewing the IRS transcript of account. Using our example of taxes owed for 2010. Let us assume the tax was filed late and was not filed and assessed until April 15, 2012. The 2010 income tax will be eligible for discharge on April 16, 2014.

Fourth, the taxes owed must have been assessed more than 240 days prior to the filing of the bankruptcy. This time is extended for the full time following an assessment where there has been an offer in compromise plus an additional 30 days. This time period is also extended were collection proceedings were suspended, during the 240 days, plus an additional 90 days.

Fifth, for all of the rules to take effect the taxpayer must have filed an actual return and not what is referred to as a "substitute for return". A substitute return filed by the taxing entity on behalf of the taxpayer will not qualify the tax to be discharged in the bankruptcy. For a tax to be dischargeable in chapter 7 bankruptcy a taxpayer must have filed the return.

Finally, the tax return itself must not be -fraudulent and the taxpayer must not have engaged in any willful evasion to invade the tax liability. The taxpayer need not have committed actual fraud to have filed a fraudulent return. Courts have looked to a number of different behaviors to determine that a tax return was either fraudulent, or the tax payer engaged in willful evasion of the tax. These behaviors include such things as a gross understatement of income, the failure to file a tax return or filing late returns, implausible behavior by a taxpayer, failure to cooperate with the IRS, and depositing income in someone else's bank account, have all been concluded to be indications that tax fraud may have existed. In general taxpayers who are members of organized tax protester organizations will have difficulty discharging their own page tax liabilities in the bankruptcy court.

Discharging income taxes in bankruptcy can be a very complex calculation. To determine if a tax can be discharged in chapter 7 bankruptcy one must examine the status of the tax, the kind of tax owed, timing issues surrounding the filing of the tax itself. Other issues concerning the taxpayer's behavior can also effect the ability to discharge the tax. It is always advisable to consult an experienced bankruptcy attorney before attempting to determine if a particular tax can be discharged in bankruptcy.