There is a common misconception that income taxes are never dischargeable in bankruptcy. In fact, you can discharge your back federal, state, and local income taxes in Chapter 7, Chapter 13, and Chapter 11. Penalties and interest are also dischargeable. Determining which back taxes are dischargeable can be a little complex. However, it is possible to discharge significant income tax debt in bankruptcy, if your tax debt fits within the following rules:
The 3 Year, 2 Year, and 240 Day Rules. The Bankruptcy code sets out specific time periods that determine if you can discharge your taxes, often called the 3-year, 2-year, and 240-day rules (or the 3-2-240 rules). Under these rules, you can discharge taxes that came due 3 years before filing for bankruptcy, as long as it has been at least 2 years since you filed the tax forms and 240 days since the taxes were assessed. These rules are often misunderstood. However, the important thing to understand is that you must meet the requirements of all three rules to discharge your taxes.
1. The 3-Year Rule. This rule states that to discharge your back income taxes, they must become due at least three years before you file for bankruptcy. Bankruptcy Code §507(a)(8)(A)(i). Typically, your federal and most state income taxes become due on or around April 15th of each year. In most cases, it is simply a matter of adding three years to this due date to determine the earliest date you can file for bankruptcy and still discharge your taxes.
Example: Joe’s 2008 federal income taxes are due on April 15, 2009. If Joe owes taxes for that year and wants to discharge them, the earliest he can file for bankruptcy is April 15, 2012 (April 15, 2009, plus 3 years).
Regardless of the initial due date, if you file for and receive an extension of time in which to file your taxes, the due date falls on the day the extension expires.
Example: If Joe in the example above obtains an extension until October 15, 2009, his tax due date is October 15th, not April 15th. Therefore, he must wait until October 15, 2012 to file for bankruptcy, if he wishes to discharge these taxes.
2. The 2-Year Rule. Under the 2-year rule, your income tax returns must have been filed at least two years before filing your bankruptcy petition. This requirement allows you to discharge your taxes, even if you filed your tax forms late, as long as you file them at least two years before filing for bankruptcy. §523(a)(1)(b)(ii).
Example: Jill’s income taxes were due on April 15, 2009. Jill did not get an extension. However, she did not get around to filing her tax forms until June 1, 2010. If Jill wants to discharge her 2009 taxes, she cannot file for bankruptcy until June 1, 2012 (two years from the date she filed her taxes AND more than three years from the date the taxes were due).
What if you did not file? If you did not file an income tax return in a given tax year, any taxes assessed by the IRS for that year are not dischargeable. §523(a)(1)(b)(i). In my Philadelphia bankruptcy practice, I sometimes see clients whose taxes would have been dischargeable, if only they had filed their tax forms. If their tax debt is significant, I may advise them to go ahead and file the tax forms, then wait to file for bankruptcy.
Quick Point: If the IRS files a return on your behalf, it is not considered a filed return for the purposes of this rule. You must still file a tax form for that year.
3. The 240-Day Rule. Taxes must be assessed at least 240 days before you file for bankruptcy under this rule or not assessed at all. As a practical matter, the date of assessment is typically on or near the date you filed your income tax form (assuming the IRS and you agree on the amount of taxes owed). However, if you file a correction or a change results from an IRS audit, the assessment date may be substantially later. §507 (a)(8)(A)(ii)
Example: Joe filed his 2009 taxes on April 15, 2009. His taxes are assessed by the IRS on the same day. Joe meets the requirements of the 3-2-240 rules on April 15, 2012. However, if Joe files a correction on January 1, 2012, the 240-day clock starts over. Therefore, he cannot file for bankruptcy until August 28, 2012 (January 1, 2012, plus 240 days), if he wants to discharge these taxes.
Example: Jill files her 2009 taxes on time on April 15, 2009. The IRS audits Jill’s taxes and finds that Jill made a mistake. She actually owes a few hundred dollars more than shown on her original tax form. The IRS assesses the new amount along with some penalties and interest on March 1, 2011. To discharge her 2009 taxes (and the penalties and interest) Jill will have to wait until October 27, 2012 to file for bankruptcy (240 days from the IRS’s new assessment).
If you are in a dispute with the IRS regarding how much you owe and plan to file for bankruptcy, you should inform your bankruptcy lawyer of the dispute. A tax dispute can impact the assessment date.
Other actions can add additional time to some or all of the 3-2-240 time requirements, including (a) making an offer in compromise, (b) having filed for bankruptcy previously, or (3) obtaining a taxpayer assistance order. §507(a)(8)(A)(i).
Quick Note: If the back taxes are an issue, it may be necessary to order an IRS “account transcript” (sometimes called a “literal transcript”) for the tax years in question. The account transcript typically includes the assessment date. Note that this is not the same as a “tax return transcript”. You can order an account transcript from the IRS over the phone or online, or using IRS Form 4506T.
Tax Evasion and Fraud. If a taxpayer willfully evades taxes or commits tax fraud, the taxes involved are not dischargeable. §523(a)(1)(C). However, the Bankruptcy Code means deliberate tax evasion, not an honest mistake.
Penalties and Interest. Penalties and interest assessed by a taxing authority are dischargeable, along with the taxes. In other words, if the taxes are dischargeable, the penalties and interest attached to them are dischargeable as well.
Tax Liens. Discharging income taxes in bankruptcy does not remove a tax lien. You can certainly file for bankruptcy with a tax lien, and the underlying debt will be discharged, if you meet the requirements of the 3-2-240 rules. However, the lien against property you acquired before bankruptcy still stands. We will discuss tax liens and what can be done about them in the next post in this series.
Other Taxes. The 3-2-240 rules apply to federal, state, and local income taxes. (Pennsylvania income tax is dischargeable in bankrupty.) However, they do not apply to other taxes. Some other taxes, such as the employer part of the payroll tax are sometimes dischargeable in bankruptcy, but under different rules.
Statutes of Limitations on Taxes. In addition to bankruptcy relief, there are separate federal and state Statutes of Limitation on the assessment and collection of taxes. The rules regarding discharge of income taxes in bankruptcy are not dependent on these statutes.
Although determining the dischargeability of income taxes can be a bit complex, it should not discourage you from seeking assistance. A good bankruptcy attorney can help you determine if you can discharge your income tax liability.