Chapter 7 Bankruptcy And Tax Debt

The misconception that a person who files for Chapter 7 bankruptcy cannot get rid of tax debt is a common one. Fortunately, it is not true. In fact, unlike student loan debts, you may discharge your income tax debts if they meet certain restrictions, qualifications, and limitations, all of which are discussed here. The misconception that an individual cannot bankrupt tax debts likely flows from the fact that although some taxes may be discharged in a bankruptcy the majority of tax debts do not get discharged.

Requirements for Discharging Your Income Tax Debt in Bankruptcy

Typically, income tax debt can be discharged in Chapter 7 bankruptcy if the following requirements are met:

1. The debt is for taxes that are income-based. The only form of tax debt that Chapter 7 is able to discharge is income-related tax debts. As such, the tax debt you wish to discharge must be for federal or state income tax, or gross receipts tax.  

2. The tax return was due at least three years prior. The taxes must derive from a state or federal return that was due at least three years before filing for bankruptcy. This includes all applicable extensions on the taxes. So for example, if you disclosed the taxes on a 2005 return for, and the extensions to file that return were up on October 15, 2006, the test for the tax return’s due date will be satisfied so long as you file your bankruptcy petition after October 15, 2009.

3. The tax return was filed at least two years ago. You have to have filed the return at least two years prior to filing for bankruptcy. If you had the IRS file a substitute for the return, that will not satisfy the requirement. In order to avoid any additional challenges from the tax authority, you have to ensure that the return is signed properly, mailed properly, and complete enough to qualify as a tax return. For instance, in the example used above, if the extensions to file the 2005 tax return ran out on October 15, 2006, and you then filed the tax return on April 15, 2008, after which you filed for bankruptcy on October 15, 2009, then you will unfortunately not be permitted to discharge the tax debts. Although you will have passed the tax return due date test, you will not have met the tax return filing date requirement. In this situation, you’d need to wait at least until two years after the April 15, 2008 filing date, or until April 15, 2010, before filing for bankruptcy.

4. The taxes were assessed (meaning liability was entered into the taxing authority’s records) at least 240 days prior to the date on which you file for bankruptcy. This time requirement can be extended, in situations where an offer in compromise occurred between you and the taxing authority, or if you have filed for bankruptcy in the past.

5.  No willful evasion of tax debts or tax fraud. Your tax return cannot have been frivolous or fraudulent, and you cannot have been found guilty of intentionally evading any tax laws. If the return was filed jointly and fraud is suspected, the taxing authority would be required to prove that both you and the other person listed on the return (your spouse or now ex-spouse) each committed a fraudulent act in regard to the relevant tax return, or that you both willfully attempted to evade paying the taxes so that the court would discharge your tax debt.

Tax Debts Which Cannot Be Discharged

Certain tax debts, like those which are not related to income tax, cannot be discharged when you file for Chapter 7 bankruptcy. These kinds of non-dischargeable tax debts are discussed below:

1. Tax liens. Chapter 7 bankruptcy discharge of income tax debts will eliminate your personal obligation to satisfy the tax debt, and will also stop the taxing authority from pursuing the money in your bank accounts or wages. Tax liens or secured taxes, however, will stay attached to your property. This is the applicable rule only with respect to tax liens which have been recorded against your assets prior to the time you filed for Chapter 7 bankruptcy. So, although you may not be personally liable for a tax debt, you will need to pay off the lien using any profits you gain from selling the property in question.
2. Recent property taxes. If you incurred any property taxes before you filed for bankruptcy, those property taxes will not be dischargeable. However, this is applicable solely to property taxes which were payable within a year of your filing for bankruptcy. As such, you may discharge any personal liability for property tax that was payable over one year before you filed for bankruptcy.  However, you should keep in mind, that a lot of counties may attach a lien to your real property upon an assessment up to one year afterwards. So, if your property does have a lien against it for the property tax, that lien will still be there after the tax debt is discharged in Chapter 7 bankruptcy, though your personal liability will be eliminated.
3. Taxes that must be collected or withheld by a third party. This applies to any supposed “trust fund” taxes like Medicare, FICA, or any income tax than must be withheld from employee’s pay by an employer. It also applies to sales tax paid by the bankruptcy debtor’s customers, which the debtor is required to submit to a governmental authority.
4. Certain excise taxes, customs duties, or employment taxes. The applicability will vary depending on the specific time period.
5. Any non-punitive tax penalties incurred on non-dischargeable taxes, where the transaction or event which led to the tax penalty took place less than three years prior to your filing for Chapter 7 bankruptcy.
6. Finally, any tax credits or refunds you received in error, which relate to non-dischargeable taxes.

If you have tax debts you should consult with a Albuquerque bankruptcy lawyer in our office for a free consultation.