In my last post – the one about the taxation of cancellation of debt income – I promised I’d write about discharging income taxes in bankruptcy.  In fact, I recently published an article on the subject, but the flavor was a bit dry and technical.  I’ll try to make today’s version a bit less so.

By the way, although some articles on that site are ghost-written, I really did write the article.

I.          Discharging Taxes In Bankruptcy

There are two possible scenarios:  discharging taxes in a bankruptcy other than a completed Chapter 13 plan, and discharging them through a completed Chapter 13 plan. 

A.        Discharging Taxes Other Than In A Completed Chapter 13 Plan

To discharge an income tax debt in a Chapter 7, 11, or 12 bankruptcy, or through a Chapter 13 hardship discharge without completing the plan, the tax debt must satisfy three requirements.

1.        File Bankruptcy Three Years From The Due Date Of The Return

The day you file your bankruptcy papers must be more than three years after the date your return was due – with extensions.  For example, if the tax year in question is 2007, then the date your return was due, with extensions, was October 15, 2008 – not April 15, 2008.  Therefore, to satisfy this requirement you can’t file the bankruptcy papers before October 16, 2011.  Notice that this requirement does not focus on whether you actually filed the return, just on when the return was due.

If you’ve looked at 11 U.S.C. § 523(a)(1) – the subsection dealing with the non-dischargeability of tax debt – you might wonder where I got this three-year requirement.  The wording of that subsection:

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)(3) or 507 (a)(8) of this title, whether or not a claim for such tax was filed or allowed;

(B) with respect to which a return, or equivalent report or notice, if required—

(i) was not filed or given; or

(ii) was filed or given after the date on which such return, report, or notice was last due, under applicable law or under any extension, and 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;

makes no mention of this three-year requirement.  This requirement comes from the reference in the underlined portion to 11 U.S.C. § 507(a)(8), which focuses on:

. . . a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition— (i) for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition . . .

2.        Two Years From The Date Of Filing The Return

You must have actually filed a legitimate, non-fraudulent return for the tax year in question at least two years before you file your bankruptcy papers.  This is what 11 U.S.C. § 523(a)(1)(B) quoted above is all about.  Continuing with the previous example, for you to be able to file bankruptcy papers on October 16, 2011, you must have actually filed the return no later than October 15, 2009.  By the way, if the IRS or FTB files a “substitute for return” on your behalf because you never filed a return, then you can’t satisfy this requirement.  The moral:  file your returns each year.  You never know when that might come in handy.

3.        Two Hundred Forty One Days After The Assessment

The third requirement to get rid of the tax debt focuses on the date the taxing authority assessed the tax debt – i.e., entered it into its records as a legitimate tax debt that you owe.  If you’re going to get rid of the debt, then they cannot have assessed the tax debt during the 240-day window immediately prior to your filing the bankruptcy papers.  Thus, in the previous example, if you wanted to file your bankruptcy papers on October 16, 2011, the taxing authority cannot have assessed the tax after February 18, 2011.  This particular requirement can be problematic because the 240-day clock is tolled during an offer-in-compromise, plus 30 days, and during any time in which a stay of proceedings against collections in a prior bankruptcy was in effect, plus 90 days.  See 11 U.S.C. § 507(a)(8)(A)(ii).  In applying this third requirement, you can determine the appropriate chronology by reviewing your tax transcript, which you can order from the taxing authority.  Then file 241 days after the assessment.

In sum, an income tax debt that satisfies all three of these requirements is dischargeable under any chapter.  However, things are less stringent in a non-hardship Chapter 13 discharge.

B.        Discharging Income Taxes In A Completed Chapter 13

There are two ways you can receive a Chapter 13 discharge.  First, you can receive a non-hardship discharge under 11 U.S.C. § 1328(a) by making all of your Chapter 13 plan payments.  Second, you can receive a hardship discharge under 11 U.S.C. § 1328(b), without making all of the plan payments, if:  (1) you become unable to complete the plan due to circumstances beyond your control, (2) you have repaid your general unsecured creditors through the plan at least as much as they would have received if you had done a Chapter 7 liquidation, and (3) modification of your plan is not practicable.

The difference in federal income tax dischargeability between the non-hardship and hardship discharges lies in 11 U.S.C. § 523(a)(1)(A) quoted above.  That provision does not apply to a completed Chapter 13 discharge.  Thus, the three-year and 240-day rules do not have to be met.

II.        Making The Shortened Tax Year Election

A.        Splitting The Tax Year In Two

If you file a bankruptcy under either Chapter 7 or 11, you can split the year you file into two shortened tax years.  The enabling statute is from the Internal Revenue Code:  26 U.S.C. § 1398(d)(2).  If you choose this election, the first shortened year begins on January 1, and ends on the day before you file the bankruptcy papers.  The second shortened year begins on the bankruptcy filing day and ends on December 31.

If you make this election, then any tax you owe for the first shortened tax year becomes an allowable claim against your bankruptcy estate, as a claim arising before your bankruptcy filing.

If you don’t make the election, then the IRS can’t collect any of that year’s income tax liability from the liquidation of any nonexempt assets in your bankruptcy estate.  However, the IRS can certainly collect the tax from your postpetition earnings – i.e., the money you make after you file your bankruptcy papers.

B.        You Have To Have Nonexempt Assets To Make The Election

An important limitation to splitting the tax year in two is the requirement you have nonexempt assets.  These assets are, of course, available to pay your creditors – including the IRS – in your bankruptcy.

If you have some nonexempt assets, and if you have a tax liability for the prepetition portion of the year, then it makes sense to make the election.  This is because the tax liability for the first shortened year is a prepetition claim that will be paid, at least in part, from the proceeds of the liquidation of your nonexempt assets – which you wouldn’t get to keep anyway.  Consequently, your effective personal tax obligation for the year is reduced by the amount paid through the bankruptcy estate liquidation.

III.       Conclusion

The interaction between income tax law and bankruptcy law is vast and extremely complex.  To get a more complete picture of the interaction between tax law and bankruptcy law, and its application to your circumstances, please discuss your case with a knowledgeable Los Angeles and Orange County bankruptcy lawyer.