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This information is provided to give you an overview of the bankruptcy law as it applies TODAY to the discharge of Federal taxes.  The information contained herein is believed to be accurate, but because of the ever-changing law, you must – repeat, must – consult with a bankruptcy attorney who can evaluate your personal financial situation and provide you with accurate, timely advice!

You have read or heard that the bankruptcy laws were dramatically changed in 2005.  Most of the major changes become effective for cases filed on or after October 17, 2005, while others are already in effect.  As noted on one of my associate attorney’s website, regardless of your personal situation, if you are planning on filing bankruptcy, it will be easier and cheaper to file it prior to the effective date.  Do not wait until the last minute.

I am providing a link to a local bankruptcy attorney,  Mark J. Markus, whose office is in Studio City, who has represented several of my clients in bankruptcy litigation.   I have had very positive feedback from these clients regarding Mark’s ability to get them through the bankruptcy process quickly.

Mark has a very informative website, and an extensive discussion on the discharge of tax liabilities (as well as on the changes in the new bankruptcy law).  If in reading both of our sites you find anything that is inconsistent, Mark is the expert in this subject and I recommend you follow his guidance.  By the way, if you do find anything that is inconsistent, I would appreciate an E-mail about the inconsistency so I can resolve the issue.

The following information is primarily based on the current law (not the new legislation that goes into effect on October 17), and mostly to Chapter 7 bankruptcy (where the debts are discharged).  Chapter 13 (the wage-earner bankruptcy where a plan of repayment is set up) has different rules that I will not address here.  Check out Mark’s site for more information on Chapter 13.

  • Have the tax returns actually been filed?  Only personal income taxes that have been filed by the taxpayer can qualify to be discharged in a Chapter 7 bankruptcy.  Returns prepared by the IRS under its authority pursuant to Section 6020(b) of the Internal Revenue Code cannot be discharged except under very unusual circumstances.  These returns are called “Substitute for Returns” (SFR for short).  Chapter 13 does permit the discharge of SFR (but not under the new law!).  There are several unusual situations that can permit the discharge of a SFR in a Chapter 7 (such as when the IRS has not assessed the SFR, and the taxpayer files their return)
  • Are the taxes pertaining to returns that were due over three years ago (including extensions)?  For example, on April 16, 2005, the calendar year 2001 return (that was due on 4/15/2002) will be the most recent return that can be discharged.
  • Were the returns filed at least two (2) years ago? 
  • Were the taxes assessed long enough ago to qualify for discharge in Chapter 7 Bankruptcy?  Generally 1040 taxes that are for a period for which a return was due at least 3 years ago, that are based on returns that you filed two or more years ago, and were assessed over 240 days before date of bankruptcy filing, will qualify for discharge.  Other federal taxes may not qualify for discharge, although interest and penalties possibly could.
  • Have you filed Chapter 7 Bankruptcy before?  If so, what was the discharge date?  Generally, you can file Chapter 7 again after waiting 6 years.
  • Does the IRS have liens filed against your real property?  Generally, the liens will survive bankruptcy and the IRS will be waiting for you on discharge if you had exempt property that was not taken by the bankruptcy court (such as a pension plan balance).  The bottom line is that bankruptcy usually will not save your real estate if a Federal Tax Lien has been filed in the county where the property is located.  Also, homesteading your home may protect part of your equity against other creditors, but it is generally ineffective against the IRS Federal Tax Lien.
  • Are taxes the only reason you are considering bankruptcy?  If so, you may want to consider an Offer in Compromise first as the IRS usually takes your ability to discharge the taxes in Chapter 7 into consideration.  This often requires an administrative appeal to the Service Center or Area Collection Office denial of acceptance to your local Appeals Office of the IRS.  If you meet the objective requirements for offer qualification,  you usually will be successful on appeal.

Types of Bankruptcy for Individuals
The two most frequent types of filings for individuals are Chapters 7 and 13.  Chapter 7 (Liquidation) is the most common form of bankruptcy I have seen.  Chapter 13 generally does NOT discharge any debts.  It is essentially a payment plan consisting of 5 years of payments (that you may not be able to make as the trustee).  However, there are certain situations where Chapter 13 may be the better choice.  That is the reason you MUST consult with a bankruptcy attorney who will thoroughly review your personal financial position and make the proper recommendation.

As a recap, under current law, you can discharge (wipe out) debts for federal income taxes in Chapter 7 bankruptcy only if all of these five conditions are true:

  1. The taxes are income taxes. Taxes other than income, such as payroll taxes, Trust Fund Recovery Penalty or fraud penalties, can never be eliminated in bankruptcy.
  2. You did not commit fraud or willful evasion.  You did not file a fraudulent tax return or otherwise willfully attempt to evade paying taxes, such as using a false Social Security number on your tax return.
  3. You pass the three-year rule.  The tax return was originally due at least three years before you filed for bankruptcy (including extensions).  To illustrate, a 2000 tax return was due on 4/15/2001.  You cannot file bankruptcy before 4/15/2004 (3 years later) if you want to discharge the taxes owing on the 2000 return.
  4. You pass the two-year rule.  You actually filed the tax return at least two years before filing the bankruptcy — having the IRS file a substitute return for you doesn’t count unless you agreed to and signed the substitute return.  To illustrate, you filed a delinquent 1998 return on 6/30/2002.  While the due date for the 1998 return was 4/15/1999 – more than three years before today, you cannot file bankruptcy until 6/30/2004 – two years since you FILED the delinquent return.  
  5. You pass the 240-day rule.  The income tax debt was assessed by the IRS at least 240 days before you file your bankruptcy petition, or has not yet been assessed.   This typically pertains to audit (examination) adjustments to your return.   For example, your 1999 return may have been due more than three years ago (4/15/2000), filed more than two years ago (4/15/2000 if timely filed), but the audit adjustment was not assessed until 4/10/2003 (just before the statute expired on 4/15/2003).  You must wait 240 days AFTER the date of assessment (4/10/2003) before you can file bankruptcy and have that assessment discharged.  The 240 day period my be extended by certain acts, such as the filing of an Offer in Compromise.  In that circumstance, the period is extended for the duration of the offer’s consideration, plus 30 days.

Here is a recent Tax Court case that addresses some of the issues the Court considers in determining if taxes can be discharged. 

Christine Lynch, (Bankr SDNY 9/25/2003)

A bankruptcy judge in New York, pointing to the debtor’s lavish lifestyle, refused to relieve her of liability for tax obligations owed to IRS that totaled about $600,000.

Under the Bankruptcy Code, a debtor may be discharged from tax liabilities for tax years for which a return was due more than three years before the filing of the bankruptcy petition. But discharge from a tax debt is not available if IRS establishes that the taxpayer willfully attempted in any manner to evade or defeat the tax. A willful intent is established if the debtor (a) had a duty to pay the tax, (b) knew of that duty, and (c) voluntarily and intentionally violated the duty.

Christine Lynch was a well compensated municipal bond salesperson. Following the advice of her accountant, she invested in a tax shelter partnership which generated losses which she deducted on her ’80, ’81, and ’82 returns. IRS’s disallowance of the partnership losses (for lack of a profit motive) was sustained by the Tax Court, but not until ’96. Her liability for those years was originally about $57,000, but because of the accrual of penalties and interest over the years, had grown to $360,000 by the end of ’96. She also owed additional taxes for ’93 to ’95. This was due to the fact that only a portion of the taxes were satisfied through withholding by her employer and she made no additional payments.

In Dec. ’96, Lynch submitted an offer in compromise for about 25% of the total, based on inability to pay. The offer in compromise listed her monthly income as $26,000 and her total necessary monthly expenses as $27,000. These monthly expenses included rent of more than $6,000 for a 3-bedroom apartment on New York City’s Central Park West which she claimed was necessary to maintain her personal relationship with her bond customers who were often entertained there. Charges on her credit cards averaged $2,500 a month. Religious and charitable contributions ran about $20,000 a year, most of which related to a religious organization in which she was an ordained minister and consisted of tithing and trips to California and China for “spiritual education.” IRS rejected the offer in compromise.

In ’99, she filed a voluntary petition under chapter 7 of the Bankruptcy Code. She was granted a discharge with respect to all debts that were dischargeable. She then began an adversary proceeding raising the issue of the dischargeability of the tax liabilities.

The bankruptcy court recognized that nonpayment of tax alone is not sufficient to bar discharge of a tax liability. Thus, at least part of one’s income can be used to pay personal living expenses without running afoul of the deemed willful intent; so long as the payments can be regarded as non-discretionary. Clearly, basic food, shelter, medical services, and day care would normally be considered non-discretionary. But the expenditures here went beyond those needs. For example, the court felt that a 3 bedroom apartment (for a childless couple) in a doorman building on Central Park West at a cost of more than $72,000 a year was not a necessity. Paying the incremental cost of such housing while income taxes were unpaid was a discretionary expenditure.

Similarly, the court said that payment of tax obligations cannot be evaded by making gratuitous transfers out of religious motivation, even if sincere. A debtor cannot give his assets away when doing so is at the expense of paying creditors.

The court also looked at her extensive travel to the west coast and China, her credit card purchases (the bulk of which, based on the merchants involved, appear to be discretionary), and tuition (for the debtor and her husband, not for a child). In the court’s view, the totality of these expenses represented a classic array of discretionary expenditures, all in lieu of paying taxes.

The court also focused on the fact that she cancelled direct deposit of her paychecks immediately after IRS rejected her offer in compromise. It felt that the purpose for this move was to make it more difficult for IRS to garnish her salary. The cancellation of direct deposit was an affirmative act to evade the payment of taxes.

From its analysis of the facts, the court concluded that at least a majority of the taxes could have been paid in meaningful amounts but for the manner in which the debtor prioritized her spending.

The court next considered whether it could grant a partial discharge, i.e., to the extent that even without steps to evade, a debtor could not afford to pay. Although this point has an arguable basis in equity, the court found the plain meaning of the statute to be to the contrary. A finding that the debtor willfully attempted to evade or defeat the tax disqualifies the debtor from discharge of any portion of the debt.