Can bankruptcy get you out of a bind with the IRS and eliminate your tax debt?
If this was a true or false law school exam, I would say that’s a trick question. The answer is both – bankruptcy can discharge tax debt, and it can’t.
There are many rules in the bankruptcy code that must be followed to have a tax debt discharged. And those rules make some taxes dischargeable, and some not. You can’t always just file bankruptcy and poof!, the IRS is gone. But if you know the bankruptcy discharge rules, and follow those rules before you jump in, then yes, bankruptcy can be a friend in solving your IRS problem.
Here it is a nutshell: Bankruptcy makes some debts easy to discharge, like credit cards and medical bills. This is because Congress does not consider those debts to be of a type where extra effort has to be exerted for a fresh start.
Congress gives the IRS a chance to collect unpaid taxes before they can be discharged in bankruptcy. That is different from, say credit cards, where there is no direct law giving credit card companies time to collect the debt before you can say bye-bye to them. Congress has also made some taxes – like unpaid payroll taxes, or tax fraud – never dischargeable in bankruptcy.
Sometimes, you are ready to file bankruptcy and we determine that the time the IRS is allotted to collect has already expired, and you can immediately file bankruptcy and be done with your taxes, whether the IRS likes it or not.
Other times, we may have to put the IRS on hold and buy a little bit of time to get your bankruptcy filed so your taxes can be eliminated.
And there may be times where your taxes cannot be discharged in bankruptcy no matter how long you wait to file, such as when you owe employment taxes, have tax fraud, or your debt is the result of an IRS substitute for return.
Here, then, are the rules to making the IRS go away with bankruptcy.
First, the timing rules – how old must your tax debt be to wipe out the IRS in bankruptcy – there are three main rules to follow:
1. Three Year Rule. Your bankruptcy must be filed at least three years after your tax return was due to filed with the IRS, including extensions.
Example: You owe the IRS for 2010 taxes. Your 2010 tax return was due to be filed with the IRS on April 15, 2011. Your tax debt is eligible for bankruptcy after April 15, 2014.
2. Two Year Rule. Your bankruptcy must be file at least two years after your tax return was actually filed.
Example: You owe the IRS for 2010 taxes. You filed the return late – on June 1, 2013. Your debt is eligible for bankruptcy after June 1, 2015.
3. 240 Day Rule (usually, eliminating tax debts from an IRS audit). Your bankruptcy must be filed at least 240 days after the IRS puts the balance you owe on its books (called an assessment). This rule usually applies in audit scenarios, when the IRS finds you owe them money after your return has been filed. After the audit is complete and the IRS puts the money owed on its books, you have to wait 240 days to file the bankruptcy.
Example: Your 2010 tax return was due on April 15, 2011, and filed on time. The IRS then audited you, with audit completed and tax owed put on the IRS’ books on February 1, 2014 (assessment). Your tax debt is eligible for bankruptcy on October 1, 2014, which is 240 days after the audit assessment was made, and more than three years since the return was filed.
All three of these rules – the Three Year Rule, the Two Year Rule, and the 240 Day Rule – must be met before you file bankruptcy.
But be careful – there are traps to avoid on the way to beating the tax bankruptcy timing rules. Avoid these actions, which can extend the timing rules:
4. Filing an Offer in Compromise before the 240 Day Rule Expires. Once the IRS puts a balance due on its books, filing an offer in compromise within 240 days of that assessment tolls – or extends – the 240 day waiting period, plus 30 days. If you file an offer in compromise within 240 days of an IRS assessment and your offer in compromise is rejected, you have just set the clock for the entire time the offer was being investigated, plus whatever time had not yet expired on the 240 days, plus 30 days.
In other words, think twice before submitting a compromise to the IRS if your taxes are newer – that is, assessed by the IRS within 240 days.
5. Filing a Timely Collection Due Process Appeal with the IRS. Before the IRS can levy your property, they have to send you a notice, called a Final Notice of Intent to Levy. Within 30 days of this notice, you have the rights of due process to file an administrative appeal with the IRS, disputing and stopping the levy.
While the appeal is pending and solutions are negotiated, the IRS cannot levy or seize your property by law. This is commonly known as a Collection Due Process Appeal.
However, the Three Year Rule and 240 Day Rule are tolled while your Collection Due Process Appeal is pending with the IRS, plus 90 days.
In other words, if you are considering bankruptcy, think twice before timely filing a Collection Due Process Appeal with the IRS.
Tip: To avoid the harsh effect of of the tolling, file your Collection Due Process Appeal late, which is defined by the IRS to be within one year after the date of the Final Notice of Intent to Levy. IRS administrative procedure allows this late appeal, and it does not invoke the tolling effects of the bankruptcy laws.
In addition to the timing rules, a few more items have to line up correctly as it relates to the type of tax you owe, and how you came about owing them. Make sure the taxes you owe are consistent with these bankruptcy laws:
6. You Must Owe the IRS Income Taxes. That means trust fund employment taxes are not dischargeable in bankruptcy. Trust fund taxes are the portion of wages that a business takes out of its employees’ paychecks for payment to the IRS. If the business does not pay the tax withheld out of its employees’ paychecks to the IRS, that debt is cannot be discharged in bankruptcy.
7. You Must Have Filed an Original Tax Return with the IRS. If you do not file your return on time, tax laws permit the IRS to file an estimated tax return for you. This is commonly called an IRS Substitute for Return. Any money you owe the IRS from a Substitute for Return cannot be discharged in bankruptcy. Only your original return can be discharged. In most cases, even if you file your original return after the IRS makes a Substitute for Return for you, your tax debt is still nondischargeable.
8. Tax Fraud. If the IRS has charged you with tax fraud, you will be unable to eliminate it in bankruptcy.
We determine whether – and when – bankruptcy is an option for you by obtaining from the IRS a transcript of your tax debts. This IRS account transcript can be analyzed to determine when your return was due to be filed; when you filed it; and if you were audited. If there are any tolling events, like the filing of an offer in compromise or a collection due process appeal, your account transcript would tell us. It will also confirm the nature of your debt – trust fund employment taxes or income taxes? – and that there are no IRS substitute returns on your record.
No permission from the IRS is really needed to file bankruptcy on them – it is more a matter of knowing and following the tax discharge rules in the bankruptcy code. The bankruptcy code forces the result you desire on the IRS. This is different from sending the IRS an offer in compromise to settle your debts, which requires the IRS’ subjective approval.
Bankruptcy can help you with the IRS – but don’t go in blindly – make sure the bankruptcy laws are applied to your situation so you know if, and when, you are eligible to discharge your taxes in bankruptcy.