I have found that there are a large number of tax professionals that do not know that personal income taxes can be discharged in a bankruptcy case.  Therefore it would logically follow that a great number of taxpayers would not know that the discharge of personal income taxes in a bankruptcy case is possible.

In the “good old days” before the 2005 change in the Bankruptcy Code, the discharge of personal income taxes in bankruptcy was a wonder to behold.  The discharge of taxes under Chapter 7 and Chapter 13 differed significantly and Chapter 13 allowed a “Super” discharge of even taxes that the taxpayer never got around to filing with the State or Federal Taxing Authority.

After the Bankruptcy Code change in 2005 the discharge of taxes was changed to what were basically the tax discharge rules of Chapter 7 before the Bankruptcy Code change.  The “Super” discharge was largely eliminated.  Today we discharge taxes in Chapter 7 cases and Chapter 13 cases in basically the same manner.  There are still some subtle differences in discharging taxes between the two chapters.  For example, the discharge of penalties and interest differs between the two chapters of bankruptcy, but that issue is looking at the trees and I’m trying to just show you the tax forest in this article (I want to outline for you the Basic Rules for Discharging Taxes in a bankruptcy case).

There are arguably Five Rules for discharging personal income taxes in a bankruptcy case.  Three of the Rules are timing Rules and two of the Rules are conduct rules.  We will address the timing rules first.

The FIRST RULE is the THREE YEAR RULE.  This rule requires that the most recent due date for the tax year at issue must be more than three years ago.  Let’s tax year 2008.  The 2008 tax return would be due  April 16th 2009 (be aware that there are many “tolling events” that might push that due date back – an extension to file for instance would make the due date October 16, 2009, but there are other tolling events to be considered too).  So, the three year period from the due date for the tax year in question would be April 16th 2012.   Three years and a day after it was first due.

The SECOND RULE is the TWO YEAR RULE.  This Rule is really only applicable to late filed tax returns.  If the tax return was filed on time the Two Year Rule would always be met.  However, often tax returns are filed late.  The TWO YEAR RULE requires that the tax return for the tax year in question was filed with the taxing authority (State or Federal) at least two years before the filing of the bankruptcy case.  So, if the 2008 tax return is not filed until October 10th 2011, then the bankruptcy case cannot be filed until October 11, 2013 at the earliest – more than two years after the filing of the tax return.  The due date of the tax return is not an issue in the TWO YEAR RULE, the relevant issue is the date when the return was actually filed.

The THIRD RULE  is the 240 DAY RULE.  The 240 Day Rule requires that the tax sought to be discharged has been assessed by the taxing authority more than 240 days prior to the filing date of the bankruptcy petition.  The period of time at issue in this Rule may be “tolled” or extended however.  The time period is extended for the period of time following assessment where the taxpayer or his representative made an “offer in compromise” with regard to the tax at issue, plus an additional 30 day period after the offer is rejected or accepted.  So to satisfy the 240 Day Rule, the tax in question must have been assessed for more than 240 days, plus any time an offer in compromise was pending, plus an additional 30 days, prior to the filing date of the bankruptcy petition.  The 240 day time period would also be tolled during the time the automatic stay was in place in a prior bankruptcy case, plus an additional 90 days – and there are other tolling events.

The date of assessment of the tax in question will be reflected on an IRS Account Transcript – the date of assessment of a State tax is a little trickier to determine and varies from State to State.

So, those are the three timing rules: The Three Year Rule; The Two Year Rule and the 240 Day Rule.

Now we take a look at the final two Rules, the Conduct Rules:

The FOURTH RULE is the NON-FRUDULENT RETURN RULE.  A discharge is not available in a bankruptcy case for a tax with respect to which the debtor made a fraudulent tax return.  The case law on what amounts to “fraud” in a tax return is many and varied.  Courts look at different indicators of fraud, understated income, failure to cooperate with the IRS,  etc.   Some courts have found a requirement that there be affirmative acts on behalf of the taxpayer and other courts have found that an affirmative act is not necessary to constitute fraud.

The burden of proof is on the taxing authority to prove fraud.  Thus claims of non-dischargeability based upon an alleged fraud in the return are not common.  When it is conduct that is alleged to be the basis for a nondischargeability claim it is usually based upon Rule number 5.

The FIFTH RULE is the NO WILLFUL ATTEMPT TO EVADE THE TAX RULE.  The Fifth Rule requires that the taxpayer must not be guilty of a willful attempt to evade the tax in question.  What constitutes a willful attempt to evade a tax varies widely among the reported decisions on the issue.  Because of the widely varying opinions from the courts on what is a willful attempt to evade a tax, bankruptcy counsel must carefully review any conduct that might be construed as a willful attempt to evade the tax in the jurisdiction in question.

OK, there you have the BASIC FIVE RULES REGARDING THE DISCHARGE OF PESONAL INCOME TAXES IN BANKRUPTCY.  Be aware that these are only the basics.  There is much to consider and a review of the tax transcripts for the tax years in question is a necessity.  A knowledgeable bankruptcy attorney is a prerequisite.

In summary, the FIVE BASIC RULES:

  1. The Three Year Rule: The tax sought to be discharged must be due and owing for a period of more than 3 years from the most recent date the tax return was due (allowing for tolling events).
  2. The Two Year Rule: The tax return for the tax year in issue must have been filed more than two years before the bankruptcy is filed.
  3. The 240 Day Rule: The tax to be discharged must have been assessed more than 240 days before the bankruptcy case is filed (don’t forget to look at tolling events like an offer in compromise or a prior bankruptcy case).
  4. The Non-Fraudulent Return Rule: The tax return for the tax to be discharged must not have been fraudulent.
  5. The No Willful Evasion Rule: The taxpayer cannot be guilty of a willful attempt to evade the tax.

There you have it, the BASIC rules that must be met for discharging personal income taxes in Bankruptcy.