Sometimes taxes can be discharged in bankruptcy. The rules are technical. There are six basic rules that govern whether the tax can be dischargeable. We will simplify each basic rule, so that you may better help your clients.
CPA’s Must Understand Bankruptcy Options
For people with serious debt problems, bankruptcy helps, not hurts. So very often, bankruptcy improves a person’s credit rating, because it eliminates further late payments, excessive balances, and sometimes tax liens.
Along with the U.S. Tax Code, our Congress also gave us the U.S. Bankruptcy Code. This is also known as Title 11 of the United States Code, or Title 11 U.S.C. Bankruptcy is a financial tool that was expressly authorized by our government.
There is no negative stigma in requesting this court’s protection from unmanageable debt. There is nothing unpatriotic about seeking lawful ways to reduce tax, especially if any accumulated back tax debt cannot be paid within reasonable means. Do not discourage your clients from seeking this option.
Every year, many thousands of people legally eliminate their IRS back tax debt this way. If your client needs it, bankruptcy is lawful, common and effective.
Giving (or Receiving) Advice on Taxes in Bankruptcy
Discharging IRS and state taxes in bankruptcy is technical, and it is tricky. Business owners, CPA’s (and even some bankruptcy lawyers) need a basic understanding of how to navigate the six basic rules to this option of eliminating tax liability.
Here are the 6 basic rules:
Rule #1 – Income Tax Rule
People ask “Can you really zero out tax debt with bankruptcy?” The answer is yes, but only income-based taxes can be discharged. Federal, state, or even local (city) income taxes fall under this category. This includes personal and corporate income taxes. It also includes self-employment taxes. Dischargeability excludes state sales taxes, payroll taxes, and excise taxes.
Rule #2 – Tax Lien Rule
Tax liens have a huge impact on whether tax can be eliminated in bankruptcy. If IRS or your state filed a tax lien, the discharge of taxes becomes more difficult.
For example, the Illinois state tax lien will attach to a Naperville client’s home. If Client retains the home through the bankruptcy, the tax lien will still be there after the bankruptcy case is over, much like a mortgage loan remains.
In our example, a tax lien could possibly be reduced, down to the amount of equity in the retained home or other assets.
Rule #3 –Original Tax Rule
This is very important because many people will fail, for many years, to file their own tax returns. When that happens, instead of waiting any longer, sometimes the IRS or state Department of Revenue may go ahead and file the tax returns. These are called SFR’s, meaning both “substitute-for-returns” or “service-filed-returns”. Then the government can charge tax based on its own SFR tax returns.
We could also call this the “Source of Tax “rule. Here it is: Income tax liability originated from “substitute-for-returns” or “service-filed-returns” (SFR’s) are not eligible for discharge.
For example, if IRS filed that particular year’s tax return first, the resulting tax cannot be discharged in bankruptcy. Even if the Client later filed an Original or Amended tax return after the SFR is filed, even if it shows a lesser amount of tax, that tax is still not eligible to discharge.
Rule #4 – Due Date Rule
To discharge any year’s tax liability, the bankruptcy petition must be filed after three years following the due date of that tax return, including extensions.
In 2020, the 2019 income tax filing due date was automatically extended until July 15, 2020. This rule includes automatic extensions, as well.
Rule #5 – Tax File Date Rule
To discharge any year’s tax liability, the bankruptcy petition must be filed after two years following the actual filing date of that tax return.
Remember, not everyone files their returns on time, by the due date. Sometimes Clients file their tax returns several years (sometimes even a decade or so) after the due date. So this Rule #5 is much different than the Due Date Rule.
Rule #6 – Assessed Tax Rule
To discharge any year’s tax liability, the bankruptcy petition must be filed after 240 days following the assessment date of any additional tax.
Why this rule: Typically, IRS assesses tax within 90 days of when a tax return is filed. Sometimes later, the government determines that penalties are also appropriate.
More importantly, sometimes Clients get audited years after a tax return is filed. When the audit result in more tax, the government is given about 8 months to collect the additional amount, before a bankruptcy can eliminate the additions.
Ask More Questions!
Everyone’s tax and debt situation is unique. These 6 general rules summarized here should provide anyone the proper talking points for a tax-debt options meeting with the client, CPA, or bankruptcy attorney.
J. Anton Collins is a Naperville IL based tax lawyer with Tax Law Offices and Business Tax Settlement Corp.