Breaking Down Tax Debt Dischargeability in Bankruptcy

Introduction: Filing for bankruptcy can provide individuals and businesses with a fresh financial start, but what about tax debts? Are they dischargeable in bankruptcy? In this comprehensive guide, we will explore the rules and considerations surrounding tax debt dischargeability in bankruptcy. While tax debt discharge can be complex, understanding the guidelines and seeking professional guidance can help navigate this aspect of the bankruptcy process effectively.

I. Understanding Tax Debt Dischargeability:

Types of Taxes:

Tax debts can vary depending on the type of taxes involved. Understanding the different categories will help determine their dischargeability in bankruptcy.

a. Federal Income Taxes:

Federal income taxes may be eligible for discharge under certain conditions. It’s important to review the specific criteria to determine if your federal income tax debt qualifies for discharge in bankruptcy. Factors such as the age of the tax debt and compliance with filing requirements play a crucial role.

b. State and Local Taxes:

Dischargeability rules for state and local taxes vary by jurisdiction. Some jurisdictions may allow the discharge of certain state and local tax debts, while others may not. Consult with a bankruptcy attorney familiar with your jurisdiction’s laws to understand the rules specific to your location.

c. Payroll Taxes:

Payroll taxes, such as taxes withheld from employee wages, are typically not dischargeable in bankruptcy. These taxes are considered trust fund taxes and are subject to different rules. Responsible individuals, such as employers or business owners, remain personally liable for these taxes even after bankruptcy.

II. The 3 Rules to Discharging Taxes

The Three-Year Rule:

To be eligible for discharge, the tax debt must relate to a tax return due at least three years before filing for bankruptcy. This rule applies to federal income taxes and helps ensure that older tax debts have a better chance of being dischargeable. The three-year period starts on the tax return’s original due date, including extensions, if applicable. For example, if your tax return was due on April 15, 2022, the three-year period would start from that date.

The Two-Year Rule:

The tax return must have been filed at least two years before filing for bankruptcy. This requirement ensures that the taxpayer has fulfilled their obligation to file the tax return before seeking discharge in bankruptcy. Late-filed returns or substitute returns may not satisfy the two-year rule. It’s essential to have timely and accurate tax filings to meet this criterion.

The 240-Day Rule:

The tax debt must have been assessed by the taxing authority at least 240 days before filing for bankruptcy. Assessment refers to the formal determination of the tax debt by the taxing authority. Assessments occurring during bankruptcy proceedings are not counted towards the 240-day period. This rule prevents individuals from attempting to discharge tax debts by filing for bankruptcy immediately after an assessment.

III. Non-Dischargeable Tax Debts:

Trust Fund Taxes:

Trust fund taxes, such as withheld payroll taxes, are considered non-dischargeable in bankruptcy. These taxes are held in trust by employers on behalf of their employees and are intended to be remitted to the government. Responsible individuals, such as employers or business owners, remain personally liable for these taxes even after bankruptcy. Discharging trust fund taxes would potentially allow individuals to avoid their responsibility to remit these funds.

Fraudulent Taxes:

Tax debts resulting from fraudulent activities or willful evasion are generally non-dischargeable. This includes intentionally providing false information or attempting to evade taxes. The burden of proof lies with the taxing authority to establish fraud. If they can successfully prove fraudulent intent, the tax debt may be deemed non-dischargeable.

IV. Exceptions and Nuances:

Tax Liens: Bankruptcy discharge may eliminate personal liability for tax debts, but it may not remove tax liens on property. Liens may survive bankruptcy and remain attached to the property. It’s important to understand the implications of tax liens and explore potential strategies to address them.

Offer in Compromise: In some cases, taxpayers may explore an Offer in Compromise (OIC) with the taxing authority. An OIC can provide an opportunity to settle tax debts for less than the full amount owed. It’s essential to understand the eligibility criteria and requirements for an OIC and work with professionals to navigate the process effectively.

Chapter 13 Bankruptcy: Chapter 13 bankruptcy allows individuals to create a repayment plan to address tax debts over time. Through the plan, a portion of the tax debts can be repaid, potentially with reduced interest and penalties. Chapter 13 bankruptcy provides a structured approach to managing tax debts while retaining assets.

V. Seeking Professional Guidance:

Consult with a Bankruptcy Attorney: Given the complexities of tax debt dischargeability, it is crucial to consult with a qualified bankruptcy attorney. They have the expertise and knowledge to assess your specific situation and provide guidance on the best course of action. An attorney can help you determine if your tax debts meet the dischargeability requirements, navigate the bankruptcy process, and ensure compliance with applicable laws.

Collaborate with a Tax Professional: In addition to a bankruptcy attorney, working with a tax professional can provide valuable insights. They can review your tax filings, assess any potential issues, and help you stay compliant with tax obligations. A tax professional can also assist in negotiating with taxing authorities to develop payment plans or explore other tax relief options outside of bankruptcy.