It is a common misunderstanding that bankruptcy cannot eliminate any tax liability. Although treatment of tax liability is one of the most complicated aspects of consumer bankruptcy law, the Bankruptcy Code does offer many debtors substantial income tax relief. Whether or not your bankruptcy filing relieves your tax debt depends on several factors including the nature of tax liability and the type of bankruptcy proceeding.
Type of Tax
Income Tax: Federal income taxes are eligible for discharge if they meet the discharge rules explained below
Trust Fund Taxes: Trust fund taxes refer to those taxes withheld from employee pay checks for social security and medicare (“employment tax”). The amount withheld includes the employer’s share and the employee’s share of employment tax. A business owner is personally liable for Trust Fund taxes if he supervises the collection or accounting of the tax. The employee portion of Trust Fund taxes are not eligible for discharge in bankruptcy. Sales tax collections are deemed to be held in trust and cannot be discharged. The employer’s portion of Trust Fund taxes are eligible for bankruptcy discharge if they meet the discharge rules explained below.
Other Tax: Excise taxes such as estate and gift tax, sales tax, or fuel taxes are not eligible for bankruptcy discharge.
Secured Tax Debts: In the course of its collection efforts the IRS has to power to file a tax lien to perfect its tax claim against individuals. A federal tax lien applies to all of the taxpayer’s personal property wherever it is located even if the personal property is outside Florida. The tax lien encumbers the debtor’s real property only in the county or counties where the IRS files its tax lien. Florida’s homestead exemption does not apply to tax liens.
A federal tax lien once filed makes the IRS debt a secured claim in bankruptcy and ineligible for discharge. Tax debt which is not secured by a tax lien on property is treated as a “priority debt” which means that like other priority debts it is paid in full before money is available to pay general unsecured bankruptcy creditors.
Bankruptcy Discharge Rules
Bankruptcy discharge rules are best understood as “negative rules”, that is to say, all tax debts eligible for discharge as described above (e.g., income tax etc.) may be discharged EXCEPT the following:
- Taxes for which a tax return was due to be filed within three years (plus extensions) prior to the date of filing bankruptcy. For example, the tax return for 2011 income taxes was due to be filed on April 15, 2012, (plus any extensions) , and therefore, these income taxes cannot not be discharged by filing bankruptcy filed on or before April 15, 2015 (plus the time of extensions); OR
- Taxes assessed by the IRS within 240 days before the filing of bankruptcy. Assessment date is the date that tax liability is entered on IRS records; OR
- Taxes not yet assess but still assessable; OR
- Taxes for which a tax return was filed late and filed within two years prior to filing bankruptcy ( however, some courts have held that a late filed return prevents discharge of income tax);
- Taxes of a debtor who committed fraud related to a tax return or willfully attempted to evade or defeat taxes sought to be discharged.
- Substitute tax returns cannot be discharged- those returns the IRS files on behalf of the taxpayer
In other words, eligible tax debt that does not fail any of the above five tests may be wiped out in a Chapter 7 or a Chapter 13 bankruptcy. These taxes are “dischargeable.”
The dischargeability test is somewhat different in Chapter 13 banrkuptcy. A Chapter 13 bankruptcy a debtor can discharge:
- Taxes for which tax returns were filed late but within the two years preceding the bankruptcy, provided tax assessments have either not been made or have been made more than 240 days prior to the bankruptcy filing; AND
- Taxes related to fraudulent returns or taxes the debtor willfully attempted to evade or defeat.
Discharge of Interest and Penalties: If your income taxes meet the requirements to be discharged then any interest that has accumulated will also be subject to discharge in Chapter 13 bankruptcy. The general rule is that if the event that gave rise to the penalty occurred more than 3 years before the bankruptcy then the penalty can be discharged in bankruptcy.
Chapter 7 Bankruptcy Tax Relief
Chapter 7 Bankruptcy will eliminate all dischargeable income tax debt. Chapter 7 does not avoid recorded tax liens.
Chapter 13 Bankruptcy Tax Relief
Chapter 13 bankruptcy involves a payment plan approved by the bankruptcy court under which a debtor pays some of his debts and discharges other debts.
There are two basic tax discharge rules in a Chapter 13 bankruptcy:
- Taxes not dischargeable in Chapter 13 are considered “priority debts” and they must be paid in full during the Chapter 13 plan. The amount of the priority tax debt includes interest and penalties assessed up to the bankruptcy filing date, but the assessment of interest and penalties stops once the bankruptcy petition is filed.
- Dischargeable tax debts will be paid in part during the bankruptcy plan, and the unpaid balance is wiped out upon successful completion of the plan.
Chapter 13 bankruptcy is better than Chapter 7 for some debtors. Chapter 13 bankruptcy enables homeowners to stop foreclosure and catch up past-due mortgage payments over the period of the Chapter 13 plan. Chapter 13 helps taxpayers who have assessed civil tax penalties. Tax penalties may not be discharged in Chapter 7 bankruptcy, and in Chapter 13 the penalties accrued to filing date must be paid in full during the Chapter 13 plan. However, filing Chapter 13 stops additional IRS interest and penalties which enables the debtor to payoff his IRS debts much faster than if he were unprotected by the Chapter 13 bankruptcy.