Taxes in Bankruptcy and the Two Year Rule

There is a common misconception that taxes cannot be discharged in bankruptcy.  However, if you owe taxes and plan on filing for Chapter 7 bankruptcy, you should ask at least three questions with regards to your tax debt.  Depending on the answers to the questions, the tax debt might be dischargeable and should follow up with a bankruptcy attorney

1)  Is your tax debt at least three years old?

2) Were the tax returns actually filed at least two years ago?

3) Did the taxing authority assess the taxes in the last 240 days?

The Rules to Discharge your tax debt:

Under the United States Bankruptcy Code, tax debt can be eliminated or discharged depending on how old the debt is, whether the tax return was filed, the type of tax debt and whether there is any fraud involved.

1)  Income taxes are dischargeable: Payroll taxes are not dischargeable.

2)  The tax return for the tax debt must be due (after extensions) at least three years before filing for bankruptcy.  This does not necessarily mean that the tax return had to be filed prior to bankruptcy.  For example, if your taxes are due May 1, 2010 and you did not file any extensions, then you can discharge the debt if you file your bankruptcy June 1, 2013.  This is known as the three year rule.

3)  The next rule is the two year rule.  The two year rule states for a tax debt to be dischargeable, the tax return must be filed at least two years prior to filing bankruptcy.  Although the two year rule sounds simple enough, there are differing opinions as to whether taxes are dischargeable if the taxing authority filed a “Substitute for Return.”

A Substitute for Return, is a tax return that was filed in substitution for the actual return.  In many cases, taxing authorities will file a tax return for you using estimates if you do not file a tax return.  If this happens, your tax debt might not be dischargeable.

a) Taxes filed two years prior to bankruptcy. No Substitute for Return filed by taxing authority.

If no Substitute for Return was filed by the taxing authority, then all you need to worry about is whether your returns were filed at least two years prior to bankruptcy.  If so, then you meet this prong of the rule and can move on to the next section.

b) Substitute for Return filed by taxing authority. Taxes subsequently filed two years prior to bankruptcy.

On the other hand, if the taxing authority filed a Substitute for Return, then you really need to discuss this with your bankruptcy attorney.  There are a number of differing Court opinions as to whether a tax debt is dischargeable if a Substitute for Return is filed.

i) One opinion states that if the IRS or taxing authority filed a Substitute for Return, your taxes will not be dischargeable, EVER. This is due to the fact that an actual tax return cannot be filed if a Substitute for Return was filed for you. You can amend the Substitute for Return, but you cannot file a regular tax return.  This is probably the majority position at the moment as well as the IRS’ position on the dischargeability of tax debt.

ii) In some jurisdictions across the country, if the tax payer assists the IRS with filing the Substitute of Return, then the tax debt might still be dischargeable.

iii)  Other jurisdictions state that if you file your tax return late, then your taxes debt will not be dischargeable.

iv) Finally, some courts state that as long as a tax return is filed two years prior to filing for bankruptcy, the tax debt will be dischargeable (even if a Substitute of Return was filed and assessment was made).

v) In California, the US Ninth Circuit Court of Appeals has yet to clear the discrepancies between the district and bankruptcy courts. Therefore, depending on which district in California you reside, and possibly which bankruptcy judge you get, your taxes may or may not be dischargeable.  Moreover, if you are in the Central District of California, this issue is yet to be litigated.  Therefore, if you are planning to file bankruptcy with tax debt in the Central District of California, make sure you speak to an experienced bankruptcy attorney.

4)  The next major rule is that the taxes must be assessed at least 240 days prior to filing bankruptcy.  An assessment means that the taxing authority recorded that you are liable for the debt.

5)  Lastly, your tax debt cannot be from fraud or willful evasion.  As long as you did not file a fraudulent return or willfully attempt to evade your taxes then you will pass this prong of the test.  It is possible to find fraud or will evasion if you did not file or pay taxes for a number of years.  However, fraud is determined by looking at all the circumstances in the case.