There is a common misunderstanding that taxes cannot be eliminated in bankruptcy. While it is true that certain types of taxes cannot be discharged (wiped out) in bankruptcy, income taxes can be discharged in bankruptcy if they meet the following four rules:
- The taxes are income taxes. As mentioned above, certain types of taxes cannot be discharged in bankruptcy. Payroll, sales, and excise taxes are three common types of taxes that cannot be eliminated in bankruptcy. However, personal income taxes can be discharged, which is good news for a person who can’t afford to pay their back taxes.
- The 3 Year Rule is met. If the tax return for the year in question was due more than 3 years (including extensions) before the date of the bankruptcy filing, then the taxes meet the 3 year rule and can be discharged (assuming the other rules are met). This rule is best illustrated by example:
- Example: Assume a taxpayer owes income taxes for 2012. The taxpayer’s 2012 tax return was due on April 15, 2013. So if the taxpayer files bankruptcy later than 3 years after the due date for the return (April 15, 2013), the taxpayer can discharge the 2012 income taxes (assuming the other tests are met). Therefore, as long as the taxpayer files bankruptcy after April 15, 2016, the taxpayer’s taxes will be discharged.
- The 2 Year Rule is met. Under the 2 year rule, the tax return must have been on file for 2 years before the taxpayer files for bankruptcy. This rule generally comes into play for late-filed tax returns.
- Example: Assume a taxpayer owes income taxes for 2012. Further assume the taxpayer fails to file his 2012 tax return by the deadline (April 15, 2013) and files the return over two years late on May 1, 2015. The 2 year rule requires the tax return to be on file for 2 years before filing bankruptcy, so the 2012 taxes in this scenario do not become dischargeable until after May 1, 2017. Compare this to the example under the 3 year rule. In the example under the 3 year rule, the 2012 taxes became dischargeable after April 15, 2016. However, because the taxpayer in this example filed his return late, it delayed the date the taxes can be discharged from April 15, 2016 to after May 1, 2017.
- The 240 day rule is met. The income tax liability must have been “assessed” by the IRS or state tax authority more than 240 days before filing bankruptcy. The date of assessment is the date upon which the proposed tax becomes final. The assessment date is usually shortly after the taxpayer files his or her tax return. This rule usually comes into play when a taxpayer files an amended tax return or the IRS makes changes to a tax return after an audit.
- Example: Assume a taxpayer owes income taxes for 2012 and files his return on April 15, 2013. Further assume that the IRS makes a final determination that this amount is correct and officially ‘assesses’ the tax on June 1, 2013. Under this scenario, the 2012 taxes would be able to be eliminated if the taxpayer filed bankruptcy after April 15, 2016. However, let’s assume the IRS audits the taxpayer’s 2012 tax return in January 2016. The IRS now determines that the taxpayer did not report his income accurately and now believes that he owes an additional $2,000 for that tax year. The officially ‘assess’ this tax on January 30, 2016. If the taxpayer files for bankruptcy on April 15, 2016, then only the taxes liability that was on the original tax return will be discharged. The additional $2,000 ‘assessment’ the IRS made on January 30, 2016 will not be discharged because that additional ‘assessment’ hasn’t met the 240 day rule. If the taxpayer waits to file bankruptcy until after September 26, 2016, then all of the taxes will be wiped out.
As you can see, the rules for discharging taxes in bankruptcy are focused around certain timing events. There are numerous exceptions to these basic rules, so if a taxpayer is attempting to discharge taxes in bankruptcy, it is extremely important to have someone who is familiar with the many nuances and subtleties of these basic rules.