Discharging Tax Debt in Bankruptcy

Bankruptcy may affect some tax debts, but discharge depends on the chapter, debtor, tax type, timing, and statutory exceptions. Insolvency alone does not establish that a tax liability will be discharged.

This article explores bankruptcy fundamentals in the context of tax liabilities and identifies the circumstances that support the discharge of tax debt via bankruptcy, including a discussion of the survivability of tax liens as well as alternatives to bankruptcy.

Bankruptcy in the Context of Tax Debt

Bankruptcy is a federal court process for dealing with debts through liquidation or a repayment or reorganization plan. Filing a petition does not itself grant a discharge. An eventual discharge bars collection of discharged debts as personal liabilities, but valid liens may survive. The automatic stay ordinarily pauses many collection actions when a case begins; it is different from a discharge, has exceptions and may be limited by prior filings or lifted by the court. Tax audits, demands for returns, deficiency notices and tax assessments with notices and demands for payment are generally allowed despite the stay. A notice permitted by those exceptions does not authorize every collection action.

Tax claims may be secured, unsecured priority, or general unsecured claims. Priority determines payment order and plan treatment; it is not a synonym for every nondischargeable debt. Under 11 U.S.C. section 507 and the discharge exceptions, recent income taxes and certain other taxes often receive priority and survive an individual Chapter 7 discharge. Some older income-tax debts may be discharged if all requirements are met, while other tax debts remain nondischargeable regardless of age.

Circumstances that Support the Discharge of Tax Debt in Bankruptcy

This article focuses on individual Chapter 7 and Chapter 13 cases. Their eligibility, payment and discharge rules differ. Businesses and individuals may have other bankruptcy options, including Chapter 11, which requires a separate analysis.

Chapter 7 generally involves liquidation of nonexempt property by a trustee. An individual may receive a discharge of eligible debts, subject to statutory exceptions; corporations and partnerships do not receive a Chapter 7 discharge. Insufficient assets alone do not make every debt dischargeable.

For an individual considering Chapter 7, review all of the following together; these are not a guarantee that a particular debt is dischargeable:

• Identify the kind of tax and each related charge. Taxes required to be collected or withheld for which the debtor is liable, including qualifying trust-fund liabilities, are generally not discharged in Chapter 7 regardless of age. Other employment, property and excise taxes have their own priority rules. Tax penalties require a separate analysis; a trust-fund recovery assessment should not be treated as an ordinary dischargeable penalty merely because its name includes “penalty.”
• Check the last due date, including extensions, of the required tax return. Income taxes for a year ending on or before the petition date generally have priority when the return was last due after the date 3 years before the petition, including a return not yet due when the petition was filed. An older due date alone does not establish dischargeability: assessment timing, valid filing and every applicable exception must also be reviewed.
• Confirm whether a valid return was filed and when. Taxes with no required return filed, or with a late return filed within 2 years before the petition, are generally excepted from discharge. Filing a late return more than 2 years earlier does not automatically solve the problem: the Bankruptcy Code definition of a return and controlling court decisions must be applied. An IRS substitute return under section 6020(b) does not itself count as the debtor’s qualifying return. The Ninth Circuit’s Smith decision illustrates why a later taxpayer filing after an IRS assessment may also fail to qualify; do not assume one rule covers every jurisdiction or filing history.
• Taxes associated with a fraudulent tax return or a willful attempt to evade or defeat the tax are excepted from discharge. Counsel should evaluate the facts and applicable legal standard; the passage of time does not remove this exception.
• Review assessment dates and all suspensions. Income taxes assessed within 240 days before the petition generally have priority, and taxes not yet assessed but still assessable can also have priority under the statutory conditions. An offer in compromise pending or in effect during the relevant 240-day period can extend that period by the applicable time plus 30 days. Prior bankruptcy stays, confirmed plans and qualifying collection-hearing proceedings can suspend relevant lookback periods, with statutory additional periods; the rules are not interchangeable. Separately, bankruptcy generally suspends the IRS collection limitation period while collection is legally prohibited and for 6 months afterward. Have counsel calculate the dates from the actual records rather than relying on an unadjusted age-of-debt formula.

Chapter 13 is available to eligible individuals with regular income, including qualifying sole proprietors, but not corporations or partnerships. It uses a court-approved plan to repay all or part of debts, usually over 3-5 years. It is not a process that automatically liquidates a portion of unsecured debt or guarantees retention of every secured asset. Eligibility, required payments, exemptions and secured-creditor rights must be assessed.

In a Chapter 13 filing:

• The plan generally must provide full payment of allowed priority tax claims unless the holder agrees to different treatment, under section 1322. Other tax claims may receive different treatment. Do not assume that all nondischargeable amounts, including any surviving interest, will necessarily be paid off through the plan.
• Completing the plan does not discharge every tax debt. Section 1328 preserves exceptions for trust-fund taxes, specified unfiled or late-return liabilities, fraud or willful evasion, and certain debts where the creditor lacked timely notice or knowledge of the case. Older nonpriority income taxes may be discharged if the requirements are met. A hardship discharge before all payments are completed has additional conditions and a narrower scope; it is not the same as the usual completion discharge.
• Interest, penalties, priority and secured claims require separate review under the confirmed plan and applicable law. Interest on a tax debt that remains nondischargeable can survive even if it is not paid through the plan. Do not assume that bankruptcy stops all interest or that every penalty receives the same treatment as the underlying tax.
• A plan may address an IRS tax lien and the related secured claim. Paying the amount stated in a plan does not by itself establish that every lien on every property has been released. Review the allowed secured claim, required notices and procedures, plan terms, discharge and court orders before treating property as free of the lien.
• A confirmed plan can bind the debtor and creditors, including the IRS, but its effect depends on bankruptcy law, proper notice, claim treatment and the court’s orders. Merely listing income-tax debts and remaining compliant does not establish the treatment of every debt or lien. Continue required filings and current tax payments; failures can prevent confirmation or lead to dismissal or conversion.

There are specific eligibility requirements for each kind of bankruptcy filing.  Taxpayers are encouraged to consult with tax and bankruptcy counsel to determine possible resolution options with the relevant tax authority and to ascertain whether they are eligible to pursue protection under federal bankruptcy law.

Tax Liens & Bankruptcy

A tax debt is an amount owed; a federal tax lien is a statutory claim against property rather than a judgment that must first be entered by a court. Debt discharge and lien treatment require separate review.

A bankruptcy discharge does not automatically extinguish a valid lien. A surviving lien may permit collection from pre-bankruptcy property despite discharge of personal liability. Its effect can differ for exempt, excluded or abandoned property. Review the property, notice of lien, bankruptcy orders and any available release, withdrawal, discharge of particular property or subordination procedure before a sale. These procedures have different legal effects and conditions; full payment is not a universal prerequisite for every transfer.

Do You Need a Tax Attorney?

A tax attorney can review your case and assess options for resolving outstanding tax liabilities, with the IRS or through bankruptcy counsel and a bankruptcy proceeding. Depending on eligibility and finances, a payment plan, currently not collectible status or an offer in compromise may be an alternative to bankruptcy. Currently not collectible status temporarily delays collection rather than canceling the debt. The IRS does not consider an offer in compromise while a bankruptcy proceeding remains open. No option or professional representation guarantees acceptance or a particular result.

A tax attorney can obtain account transcripts to help examine return and assessment dates, and review whether a notice of tax lien has been filed. Transcripts do not replace a legal dischargeability analysis or a review of lien records and court orders. Missing tax returns may need attention. In Chapter 13, required returns for tax periods ending during the 4 years before filing generally must be filed before the first scheduled creditors’ meeting, subject to statutory extension procedures. IRS Chapter 13 guidance explains ongoing compliance. Wage and income transcripts can help reconstruct records, but filing later does not automatically make the tax dischargeable.

Before choosing a course, review tax types, balances, notices, return and assessment dates, prior bankruptcy cases, collection hearings and settlement requests. These records help counsel evaluate timing, alternatives and the scope of an engagement. Depending on the facts, matters to discuss include:

• Assistance with filing compliance and review of Substitute for Return (SFR) balances; a corrected balance and bankruptcy dischargeability are separate questions
• An installment arrangement and separate review of eligibility for withdrawal or other relief involving a federal tax lien; an agreement does not automatically remove the lien
• A partial-pay installment arrangement, if financial and procedural requirements are met
• Currently not collectible status, when the applicable inability-to-pay requirements are met
• An offer in compromise, if eligible and outside an open bankruptcy proceeding
• Available IRS Appeals procedures, subject to the particular notice, deadlines and bankruptcy restrictions

Confirm who will handle tax advice, bankruptcy filings and any court proceedings, and agree on the engagement’s scope and fees. Representation does not guarantee that a tax debt will be discharged, a lien removed or an alternative accepted.

To request a complimentary consultation about your tax matter, contact Segal, Cohen & Landis (SCL) at (310) 285-3999. Discuss the available options, who would handle the matter and the proposed scope and cost of any representation. Any engagement and outcome depend on the particular case.