I recently returned from the American Bar Association’s Taxation conference in Washington, D.C., which is…
Expect Coronavirus Bankruptcies
With the downturn in the economy and massive job losses, bankruptcy filings will skyrocket this year.
Unpaid tax liabilities will likely be a large part of clients’ debts. There is a common misconception that income taxes are never dischargeable in bankruptcy. In reality, certain tax liabilities are dischargeable in bankruptcy. By becoming familiar with tax rules, client advisors can assist clients determine whether bankruptcy will help them.
Advisors should also explore bankruptcy alternatives for dealing with tax liabilities, including innocent spouse relief, penalty abatement, installment agreement, or an offer in compromise (OIC). Such administrative tax resolution methods avoid a bankruptcy entry on a credit report.
If those alternatives are insufficient, there are several tax rules related to bankruptcy that all advisors should know:
1. Not all taxes are dischargeable in bankruptcy.
Only income taxes are dischargeable. Taxes such as payroll taxes, trust fund taxes, or sales taxes cannot be eliminated in bankruptcy. Even worse, these non-dischargeable taxes may also be priority debts. There are other strategies to minimize these non-dischargeable taxes, but you cannot discharge them.
2. Must be 3 years or older.
More than 3 years must have elapsed since the tax return generating the liability was due, including extensions. Various acts such as prior bankruptcies, collection due process (CDP) hearings, and innocent spouse relief can extend the 3 year time frame.
In other words, to wipe out the tax liability, the bankruptcy cannot be filed until 3 years after the original due date of the tax. For example, if the unpaid tax was due from a 2015 tax return, the due date of that tax liability would be April 15, 2016. You would have to wait until April 15, 2019 to file the bankruptcy to discharge the IRS tax liability. The best way to ensure that the timing is correct is to carefully review an IRS Record of Account (beware this document is hard to understand and read)
3. Tax return filed more than 2 years before the bankruptcy filing.
The tax return must have been filed more than 2 years before than the bankruptcy petition (generally applicable to late-filed returns). Thus, even if the debt is over 3 years old, if you filed the return late and 2 years has not yet passed, then you cannot wipe out the tax liability. Note, that IRS-prepared “substitute for returns” are not considered filed returns for this purpose, and thus a tax liability assessed from them would not be subject to discharge. Therefore, it is almost always advisable for the client to file all delinquent returns and let the time frames pass before the bankruptcy petition is filed.
4. 240 day rule.
The IRS must formally have “assessed” the income tax liability at least 240 days before you file your bankruptcy petition. The IRS can extend this time period due to suspended collection activity because of an offer in compromise or a previous bankruptcy filing. The best way to make sure this has occurred is to review an IRS Record of Account.
5. Cannot be the subject of fraud or willful tax evasion.
You cannot wipe out tax liability if you filed a false or fraudulent tax return or willfully attempted to evade paying taxes. For example, if you underreported income falsely, you cannot wipe out the debt after getting caught.
Example: Joe files his 2013 tax return on April 15, 2015. The IRS assessed the taxes the same day. Joe met the requirements of the 3-2-240 rules on April 15, 2018. (This example is a bit simplified. You should always check the actual assessment date and not assume it is the same as the filing date.)
A bankruptcy filing immediately stops the collection efforts of all creditors, including the IRS. The rules governing the discharge of tax debts in bankruptcy proceedings are complex. But that should not discourage clients from considering the possibility. An experienced tax attorney can help determine if a client can discharge an income tax liability and whether other options may be available.