Many people who file chapter 7 or chapter 13 bankruptcy and owe income taxes for prior years believe that the income tax obligations will not be eliminated or discharged. However, Bankruptcy Law provides that income taxes can be discharged in certain circumstances.
In a Chapter 7 Bankruptcy where you are wiping out most of your debt, Bankruptcy Law allows you to get rid of income taxes under the following circumstances:
- At least 3 years have passed from your tax returns due date of April 15.
- Your tax return was filed at least two years ago.
- If taxes were assessed after filing, at least 240 days have passed since the assessment.
- If you have not requested an offer-in-compromise which can extend time frames for discharging your income taxes.
- No issues of fraud, tax evasion etc. exist.
In addition to these requirements, recent case rulings have made discharging taxes more complicated by requiring that the tax return be filed on or before April 15th or the return will never be considered as having been filed for purposes of filing Bankruptcy. It is unclear how this affects taxes filed after requesting an extension. This is a very harsh position taken by some courts and is currently being appealed. It will likely end up in the United States Supreme Court.
Avoid this problem by filing simply filing your taxes on or before April 15th of each year.
In a Chapter 13 Bankruptcy, where you are repaying a portion of your debt over time, the taxes may be discharged or paid over time. In a Chapter 13 Bankruptcy the income taxes may be broken out into two categories.
Priority taxes are taxes that are not dischargeable and must be paid through your Chapter 13 Plan. Non-priority taxes are taxes that meet all of the above listed requirement and may be treated just like an unsecured creditor such as a credit card or medical bill.
So, for example if you Chapter 13 Plan says that you are going to pay back ten percent on the dollar to your unsecured creditors then the IRS and State taxes owed will only be paid at ten cents on the dollar. The balance owed will go away upon successful completion of the bankruptcy.
You also need to be aware that whether you a filing a Chapter 7 Bankruptcy or a Chapter 13 Bankruptcy, if the IRS or state tax authority has filed a “Tax Lien” either in the county that you live in of with the Secretary of State of your state, that Tax Lien will not go away just because you file bankruptcy. So even though the obligation to pay the taxes may be eliminated, the lien against your assets may not go away. The most likely effect would be when you try to sell your home, the IRS or state will need to be paid off.
It is important that you discuss with your bankruptcy attorney which income taxes are dischargeable and which are not. This may require the engagement of a tax professional to determine what is and is not dischargeable based on when you filed, if you were assessed taxes years later or if you sought and offer-in- compromise which can extend time frame of the IRS to collect taxes.
You will also want to discuss with your attorney whether an income tax return should be filed before or after your case is filed. Generally, a tax refund other than earned income credit and the additional child tax credit may be collected by the Bankruptcy Trustee and used to pay your creditors. Many Chapter 7 Trustees can intercept your refund directly from the IRS.
It is not enough to just file your income tax return before you file your bankruptcy. The refunds need to be properly accounted for prior to filing. Many people make the mistake of paying family members or paying too much to creditors or comingling the refunds. This gets more complicated when one spouse is filing bankruptcy and one spouse is not filing.
While this information may answer some of your questions, it should also be clear that this is a very complicated matter which can have a profound impact on getting a fresh start through bankruptcy. Consulting with your bankruptcy attorney is the best way to understand what you need to do.