Income Taxes (Federal and State)
An "income tax" is any tax (federal or state) measured by gross income or gross receipts. Income tax debts can be discharged in bankruptcy, but only if the tax is more than 3 years old and satisfies several other legal requirements. You must analyze the liability for each tax year in question to determine whether an income tax debt is dis-charge-able. The tax debt is dis-charge-able only if all of the following requirements are met with respect to each tax year.
1. Three Year Age 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 #1. 2005 federal income taxes can not be discharged in bankruptcy unless the bankruptcy petition is filed on or after April 16, 2009.
1.1. Return Filing 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 (August 15). Example #2. If the taxpayer requests a four month automatic extension to file his 2005 federal income tax return, the taxes can not be discharged in bankruptcy unless the bankruptcy is filed on or after August 16, 2009.
1.2. Due Date Controls - Not Filing Date.
The last due date for filing the 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. Example #3. On April 15, 2006, Taxpayer requests an automatic extension to file his 2005 federal income tax return, which makes the return due on August 15, 2006. It is irrelevant to the 3 year age rule whether Taxpayer actually files the return early (prior to August 15, 2006) or late (after August 15, 2006). The taxes will be discharged only if the bankruptcy petition is filed on or after August 16, 2009.
2. 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.
2.1. IRS Filed Returns Do Not Qualify
The IRS Code authorizes 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. Example #4. TP never filed an 02 tax return. On 1/2/05, IRS files a substitute tax return on behalf of TP. The substitute return indicates a $500,000 tax liability. IRS assesses the tax on the same day. TP does not sign or otherwise consent to the filing of the return. If TP files for Ch. 7 bankruptcy on 1/2/09, he can not discharge the 02 tax debt because he never satisfied the 2 year filing rule.
2.2. 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 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. Example #5. Taxpayer ignores the April 15, 2006 deadline for filing his 2005 income tax return. He waits until May 1, 2007 (one year and 15 days after the due date) to mail the return. IRS does not receive the return until May 15, 2007. IRS immediately assesses the tax after it receives the return. The 2005 taxes will not be dis-charge-able in a Chapter 7 bankruptcy unless Taxpayer files for bankruptcy on or after May 16, 2009.
3. 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 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 #6. On 4/15/06, TP files his 05 tax return. On 11/1/08, IRS commences an audit of the 05 return. On 4/16/09, as a result of the audit, IRS assesses $100K of additional tax. TP has satisfied both the 3 year age and 2 year filing rules, but the 240 day assessment rule will not be satisfied until after 12/12/10; 240 days after IRS assessed the additional tax. To discharge the $100K of additional tax, TP can not file bankruptcy until on or after 12/13/04.
4. Post Bankruptcy Tax Assessments
A taxpayer can not discharge a tax debt which is lawfully assessed after he files for bankruptcy. A taxing authority is legally permitted to start or continue a tax audit, and assess additional tax, after a taxpayer files for bankruptcy, if the time period for assessing additional tax has not already expired. This rule is intended to force a person to pay, and prevent discharge of additional taxes assessed after a bankruptcy filing.
5. Tax Fraud and Willful Evasion
A tax debt is not dis-charge-able in a Chapter 7 case if the taxpayer files a fraud-u-lent return. A return is fraud-u-lent 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 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. However, a taxpayer might be able to discharge a tax debt in a Chapter 13 case, even if he is guilty of willfully evading payment of the tax, and possibly without paying any portion of the tax.