Bankruptcy May Remove Tax Bill

Dear Bankruptcy Adviser,

My question concerns back taxes. Obviously, they are a financial liability, similar to a debt. But I don't know whether taxes might be treated like a private debt in the event of a bankruptcy. That is, I don't know if they can be discharged. So my question is: Can an individual's personal federal and state income taxes be included in a bankruptcy claim?

-- Sarah

Dear Sarah,

Yes, you can possibly eliminate personal federal and state income taxes when you file bankruptcy. However, there are very tight restrictions on how this can occur.

I will give some general guidelines for you to use. But I believe you should consult an attorney experienced with eliminating taxes in bankruptcy. One misstep can be the difference between eliminating and maintaining tax liability. This discussion applies only to personal income taxes.

Step No. 1:

To be dischargeable, the tax return must have been due for at least three years, including any extension that may have been filed. The due date is typically April 15 of the year following the relevant tax year -- or Oct. 15 if an extension is requested. But holidays and extensions will extend the deadline. This year, for instance, taxes were officially due April 18 because of a holiday in Washington, D.C. So the three-year deadline is April 19, 2014. If an extension was requested, the three-year period will end in October 2014.

Here's an example of what I'm talking about: If you owed taxes for the 2007 tax year, the due date was April 15, 2008. If you didn't request an extension, your taxes may be eligible for elimination after April 18, 2011. But I stress the word "may." You still have to overcome the following restrictions.

Step No. 2:

You must have filed the tax returns at least two years prior to filing the bankruptcy. Some may think this is redundant, considering step one. It is not. Let's say you owed taxes for the 2005 tax year, but did not file your returns until this year, 2011. Right after you file the 2005 return, you file for bankruptcy. The taxes owed aren't dischargeable. You would have to wait two years from the date you filed the returns to declare bankruptcy if you want to try to get taxes discharged.

Please note: If the Internal Revenue Service filed a return for you by filing a substitute for return, the taxes will not be dischargeable. Even if you filed a return after the IRS assessed these taxes, the IRS takes the position that such a return is not a valid return, so these taxes are not dischargeable. It is very important to consult an attorney if the IRS filed a return for you.

Step No. 3:

The taxes must have been assessed at least 240 days prior to filing bankruptcy. This is most commonly an issue when a taxpayer is audited, or when an amended return is filed. Normally the taxes are assessed shortly after your return is filed. But if you end up getting audited, an additional assessment may take place years later.

With audits, it's common for a state to issue a new assessment after the IRS issues its assessment. A common trap is to file bankruptcy 241 days after the federal assessment. The problem: The state assessment might have been just 90 days in the past. In that case, while the recent IRS assessment may be discharged, the state assessment isn't eligible to be discharged.

Step No. 4:

The deadlines above can be extended, also known as being "tolled," by various events. Filing a prior bankruptcy, filing for an offer in compromise or filing for a collection due process hearing are all things that can extend some or all of these deadlines.

Step No. 5:

Tax evasion is a deal-breaker. If you file a fraudulent return or are guilty of willfully evading your tax liability, you cannot eliminate those taxes in bankruptcy. The IRS can review this issue on a case-by-case basis. You could comply with all other conditions, but still be unable to discharge the taxes due to fraud or evasion.

Step No. 6:

Even if the tax is dischargeable, the case isn't necessarily over. If the IRS has filed a notice of federal tax lien, it will retain that lien, which may cause you future problems. The IRS will sometimes voluntarily remove a tax lien after a bankruptcy if the tax was discharged and the debtor has very little in assets. However, if the debtor has real estate that may have equity, or an interest in a pension or 401(k) plan, the IRS will keep the lien in place. What does that mean to you? It means that, even if the tax is discharged, the IRS might still come after a portion of your assets or pension payments many years down the line.

As you can see, this is a very complicated issue. There are nuances to all these rules that space doesn't permit me to discuss. There are 600-page books on the subject. While I have said in previous columns that you can file bankruptcy without an attorney, if you have tax liability, it is very wise to discuss your situation with an experienced professional.