Discharging Taxes in Bankruptcy

CPAs can help clients include federal tax debts in their bankruptcy petition. Here are some of the key considerations and selected strategies for discharging taxes as part of bankruptcy proceedings.

August 2010
by Donald Ariail, Michael M. Smith, et al./Journal of Accountancy

With the downturn in the economy and massive job losses, personal bankruptcy filings have exploded. According to the National Bankruptcy Research Center, approximately 1.4 million bankruptcies were filed in 2009, a 32 percent increase over 2008. They included Chapter 7 bankruptcy filings, which increased 42 percent and Chapter 13 filings, which increased 12 percent. Bankruptcies in 2010 may be fewer than last year. However, in early January, The Wall Street Journal reported that bankruptcy attorneys had not yet experienced a slowdown in their workload.

CPA clients may be among those needing bankruptcy protection. Many of these clients may benefit from including federal tax debts in their petition. CPAs can play a key role by assisting clients and their attorneys in determining if and when bankruptcy is a viable alternative for resolving federal tax liabilities, by determining the composition of tax amounts owed and which tax liabilities might be dischargeable and by exploring the many bankruptcy alternatives for dealing with tax debts. Besides being aware of the tax resolution options of bankruptcy described in this article, CPAs should be familiar with administrative tax resolution methods, which the client should pursue first. These include innocent spouse relief, a request for abatement of penalties, an installment agreement or an offer in compromise (OIC).

If those options are insufficient, bankruptcy may be the best way for your clients either to secure a reasonable payment plan (Chapter 11 or Chapter 13) or to liquidate their assets to pay off all or a portion of their tax debt (Chapter 7). Using administrative tax resolution methods instead of bankruptcy may help clients avoid having a “black mark” on their credit history. However, a federal tax lien listed on the debtor’s credit report may damage his or her credit rating as much as a bankruptcy notation. Clients who may benefit from bankruptcy protection should be promptly referred to an attorney who specializes in bankruptcy law.

Not All Tax Debts Dischargeable

To be dischargeable, individual income tax liabilities must meet the following “mechanical” rules of 11 USC §§ 523(a)(1) and 507(a)(8): 

  • More than three 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, innocent spouse relief and tax assistance orders can extend the three-year time frame.
  • The tax return must have been filed more than two years earlier than the bankruptcy petition (generally applicable to late-filed returns). Note, however, that Internal Revenue Service (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 (IRC § 6020(b)). Therefore, it is almost always advisable for the client to file all delinquent returns and, if possible, let the mechanical time frames pass before the bankruptcy petition is filed.
  • At least 240 days must have elapsed since the date of an IRS assessment (generally applicable to audit adjustments and amended returns). This time frame is extended by an OIC.

Filing fraudulent returns or willful attempts to evade or defeat tax also can prevent such taxes from being discharged (11 USC § 523(a)(1)(C)). Certain other types of taxes, including withheld payroll taxes, the trust fund penalty under IRC § 6672, most state sales taxes and certain excise taxes, are never dischargeable. Such non-dischargeable taxes may also be priority debts under 11 USC § 507(a)(8).

This article has been excerpted from the Journal of Accountancy. View the full article here.