I frequently have clients who owe back income taxes to the IRS or the Franchise Tax Board (FTB). When these clients mention the taxes they tell me that they understand that tax liabilities can’t be discharged in bankruptcy. While it is true that most tax debts are not dischargeable, there is a special carve-out in the Bankruptcy Code for cases filed under Chapter 7, 11, and 12, and Chapter 13 when the discharge is granted under 11 U.S.C. § 1328(b) (the so-called “Chapter 13 hardship discharge” that is sometimes available to debtors who have not completed the plan). As a convenient shorthand and a mild abuse of terminology, we’ll refer to this group of cases as the Chapter 7 case.
Things are slightly more generous if the debtor receives a Chapter 13 discharge under § 1328(a) after completing the Chapter 13 plan. Unsurprisingly, we’ll call this the Chapter 13 case. By the way, since all of the statutory references in this post are from the Bankruptcy Code, I’ll leave off the 11 U.S.C. and just give the section.
As you will see, timing is crucial. Even one day off and the debt is not dischargeable. Thus, as you read the post you will see how important pre-bankruptcy planning is in successfully discharging income tax debts.
Two minor points before we get started: (1) this post just deals with income taxes, and does not cover other kinds of taxes such as property or sales taxes, and (2) everything in this post applies to both the IRS and the FTB. Therefore, I’ll just refer generically to “the taxing authority.”
I. The Chapter 7 Case
The exceptions to discharge – i.e., those debts that are not dischargeable – in the Chapter 7 case are found in § 523(a). In particular, the exception dealing with taxes is § 523(a)(1). The complication here is § 523(1)(a)’s reference to § 507(a)(8).
First the executive summary:
For a tax to be dischargeable in bankruptcy, it must satisfy three requirements:
- (The three-year rule) The tax return for the tax year in question must have been due (including extensions) – but not necessarily actually filed – at least three years before the filing of the bankruptcy papers,
- (The two year rule) The debtor must have actually filed a legitimate, non-fraudulent tax return for that tax year at least two years before the filing of the bankruptcy papers, and
- (The 240-day rule) The taxing authority cannot have assessed the tax during the 240 days prior to filing the bankruptcy papers.
Each of these requirements is a bit complicated and can be misinterpreted, so a little elaboration is in order.
A. The Three Year Rule
For this rule we have to look at § 507(a)(8)(A)(i), which refers to (with emphasis added):
a tax on . . . income . . .
(i) for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition . . .
Combining that with § 523(a)(1)(A)’s statement (with emphasis added):
A discharge under section 727, 1141, 1228 (a), 1228 (b), or 1328 (b) of this title does not discharge an individual debtor from any debt—
(1) for a tax or a customs duty—
(A) of the kind and for the periods specified in section . . . 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed . . .
leads to the conclusion that if the bankruptcy papers are filed even one day before the three-year mark, the tax debt is non-dischargeable.
For example, suppose the tax year in question is 2007. Then with extensions the return would be due no later than October 15, 2008. Then if the debtor files the bankruptcy papers before October 15, 2011, the 2007 tax debt is non-dischargeable.
There is absolutely no wiggle room. See Severo v. Comm’r of Internal Revenue, 586 F.3d 1213, 1218 (9th Cir. 2009) (“Because the Severos filed their bankruptcy petition on September 28, 1994, less than three years after their 1990 taxes were due on October 15, 1991, their 1990 tax liability was not discharged.”) for an example of a heartbreak case in which the bankruptcy papers were filed just seventeen days before the three-year mark, so the debt was not discharged. Notice that the focus of this particular portion of the Severo case is not on when the debtors actually filed their return, but instead on when the return was due.
B. The Two-Year Rule
For the two-year rule we have to look at § 523(a)(1)(B) and (C), which excludes from discharge any income tax debt (with emphasis added):
(B) with respect to which a return . . .
(i) was not filed or given; or
(ii) was filed . . . after two years before the date of the filing of the petition; or
(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax . . .
Thus, if the debtor never filed a return for the year in question, or filed it less than two years prior to filing the bankruptcy papers, then that tax debt is not dischargeable. Once again, there is no wiggle room. If the bankruptcy papers are filed even one day too soon, the debt is rendered non-dischargeable.
Moreover, if the taxing authority files a “substitute return” because the debtor failed to file a return, the tax has been found to be non-dischargeable because the debtor is deemed never to have filed a return. See In re Hatton, 220 F. 3d 1057, 1061 (9th Cir. 2000) (“The installment agreement and the substitute return fail to qualify as a return . . .”). This is true even if the debtor filed a return after the taxing authority had filed a substitute return. See In re Hindenlang, 164 F. 3d 1029 (6th Cir. 1999) (Form 1040 filed after the IRS filed a substitute return was deemed not to be a tax return).
However, see In re Nunez, 232 BR 778 (B.A.P, 9th Cir. 1999 where in response to an amnesty program the debtor filed a return after the IRS had filed a substitute return, and the tax debt was held to be dischargeable. Although it wasn’t emphasized in the opinion, the Court was undoubtedly influenced by the fact that the debtor filed the return in response to the amnesty program. Thus, the Court held:
The IRS argues for an absolute rule that where it prepares substitute returns and assesses the taxes due, any document subsequently filed by the debtor cannot be deemed a return. The Panel rejects that rule as contrary to the strict language of the statute.
Id. at 784.
C. The 240-Day Rule
For this one we must consider § 507(a)(8)(A)(ii), which when coupled with § 523(a)(1) excludes from discharge:
a tax on or measured by income . . .
(ii) assessed within 240 days before the date of the filing of the petition, exclusive of—
(I) any time during which an offer in compromise with respect to that tax was pending or in effect during that 240-day period, plus 30 days; and
(II) any time during which a stay of proceedings against collections was in effect in a prior case under this title during that 240-day period, plus 90 days . . .
Assessment occurs when the taxing authority officially records the tax debt as valid in its data base. How can you tell when the assessment has occurred? For that you have to get the tax transcript that shows the history of the tax year in question for the debtor. This particular transcript is not a rehash of the tax return. Instead, it gives a chronological record of everything that happened for that tax year: when the return was filed, when the assessment was made, and so on. You can obtain the transcript from the taxing authority.
When you get the transcript, look at the date of the last event – frequently an assessment – and determine the filing date for the bankruptcy papers as 240 days after the date of the last assessment – i.e., the 241st day. However, as you can see in the above-quoted statute, there are two important caveats to this calculation.
First, if the debtor enters into an offer-in-compromise, then the 240-day clock stops ticking. If the offer-in-compromise started after the 240 days had elapsed, then there is no problem with this rule. However, if the full 240 days had not passed when the offer-in-compromise started, then you’ll never reach day 241 unless you terminate the offer-in-compromise. Moreover, if you terminate the offer-in-compromise, you have to add an additional thirty days to the 240 days, meaning the time is now 270 days.
Second, if there has been a stay of collection proceedings, then the analysis is the same as with the offer-in-compromise, except that the thirty day addition is replaced by ninety days.
You might wonder what an offer-in-compromise is. While there is a lot to an offer-in-compromise, the gist is that it is a formalized process whereby the debtor offers to settle the tax liability for an amount that is less than the amount owed. If the taxing authority accepts the offer, the debtor then makes payments pursuant to it. By the way, there is considerably more to an offer-in-compromise than the debtor just calling the taxing authority to initiate a payment plan. Therefore, that sort of informal payment plan does not jeopardize the 240-day clock.
II. The Chapter 13 Case
The Chapter 13 discharge under § 1328(a) – granted upon plan completion: i.e., the debtor has made all the plan payments – excludes from discharge debts described under § 523(a)(1)(B) and (C) , but not under § 523(a)(1)(A). This means that everything discussed above applies to the Chapter 13 case except for the material referring to § 507(a)(8) (other than § 507(a)(8)(C), which we didn’t discuss because it isn’t about income taxes). Therefore, the three-year and 240-day rules don’t apply the Chapter 13 case. However, the two-year rule does apply.