Many times in my office, I’m chatting with a client about their various forms of debt. A couple times a month, a client will mention off-handedly, “I didn’t list my tax debt because I know that can’t be erased.” In bankruptcy, different debts are treated differently. For that reason, it’s important that I know all the debt my client has. In fact, sometimes tax debt can be discharged—and it is a lot of fun to tell my clients when their tax debt is eligible for discharge!
Debt in bankruptcy is put in one of three categories. I think of them as baskets:
|Secured Debt||Priority Debt||General, Unsecured Debt|
Home equity lines of credit
Recent income taxes
Wages/benefits owed to employees
Credit card debt
Some tax debt
When is tax debt is in the secured basket: Once a lien has been filed (usually with the county recorder), the tax debt is now secured. It’s important to know if you have a secured tax debt, so be sure to check before you file your case. Often, however, the full amount of the lien isn’t actually secured. For example: Your house is worth $100,000. You have a mortgage, and you owe $95,000. Then, the IRS places a lien on your property, saying you owe $15,000. In a Chapter 13 bankruptcy, only $5,000 would be treated as secured, because after your mortgage, there’s only $5,000 that the IRS lien could “attach” to ($95,000 mortgage + $5,000 lien = $100,000 value of the house).
When is tax debt is in the priority basket? Tax debt is considered “priority” if the tax return was due at least (3) years before filing bankruptcy, you filed the return at least (2) years before filing bankruptcy, and if the tax debt was assessed by the taxing authority at least 240 days before you file your bankruptcy petition.
When is tax debt is in the general, unsecured basket—and is therefore dischargeable (yay!)?
1. The taxes are income taxes. Taxes other than on income, such as payroll, withholding, and other “trust-type” taxes can never be eliminated in bankruptcy. Make sure that taxes you are seeking to discharge are 1040 taxes.
2. You did not commit fraud or willful evasion. You did not file a fraudulent tax return or otherwise willfully attempt to evade paying taxes. Debts incurred through fraud or illegal activity are not dischargeable.
3. You pass the three-year rule. To be dischargeable, the tax must be for a tax year for which the tax return was originally due at least three (3) years before you file for bankruptcy. For example, in 2020, taxes filed for tax years 2016 and before are eligible for discharge if all other conditions are present. Here is the analysis: On July 15, 2020, 2019 taxes were due. 2018 taxes were due last year, and 2017 were due the year before that—three tax years. So if you are filing your bankruptcy after July 15, 2020, debts from tax years 2016 and before may be dischargeable. However, if you filed before July 15, 2020, debts from tax years 2015 and before could have been dischargeable.
4. You pass the two-year rule. You filed the tax return for the dischargeable tax period at least two (2) years before filing the bankruptcy – having the IRS file a substitute return for you doesn’t count unless you agreed to the return, and signed the substitute return.
5. You pass the 240-day rule.The income tax debt must have been “assessed” by the IRS at least 240 days before you file your bankruptcy petition, or if it has not yet been assessed. If you get a tax return transcript (available for download at www.irs.gov ), the date of the assessment is on that document.
A note about how taxes are treated differently in Chapter 7 and Chapter 13: In Chapter 7, taxes that are dischargeable will be discharged, but you are on your own to manage the priority and secured taxes with the taxing authority. In a Chapter 13, just like in a Chapter 7, dischargeable tax debt will still be discharged (and treated the same as credit card and medical debt), but in your Chapter 13 plan, you must show how you plan to treat any secured portion of the tax debt, and priority tax debt must be paid in full by the end of the plan.
For these reasons, it is very important that if you have tax debt, work with a bankruptcy attorney who is knowledgeable about the treatment of tax debt.