Bankruptcy Tip of the Week

What IRS Taxes can be discharged in bankruptcy?

Context: I am discussing personal tax obligations which come in two varieties, 1040 Income Tax, or the Trust Fund Recovery Penalty ("TFRP"). You small business owners may run afoul of the TFRP if you didn't pay your Federal Tax Deposits relative to your employee withholding (Form 941) and therefore you get assessed personally for the withholding portion of your 941 Withholding. However, TFRP is easy in BK, the TFRP CANNOT BE DISCHARGED IN BK. But, there are some options with regard to personal income tax debt.

Discharge Rules for Taxes

So, the #1 questions, what Federal Income Taxes can be discharged in BK? There are basically 4 rules:

1. The 3 year rule. An income tax can be discharged if the Tax Return Due Date is 3 years prior to your BK petition filing date. This rule assumes the tax return was filed.
Example: ALL 1040's are due April 15. Thus, the most recent tax you could discharge this year (2008) would be income taxes from tax year 2004 because the due date for that return was April 15, 2005 and that date is more than 3 years ago.
Caveat: The extension date COUNTS. Thus, if you filed an extension for tax year 2004 so that your return was due in October, that same tax debt WOULD NOT be dischargeable until November of this year. Also, the time runs from the Due date, so if you filed your return early--say Feb '05--you still must wait 3 years from April 15.

2. The 2 year rule. For taxes that meet the 3 year rule, but you filed a LATE return, you must wait 2 years to discharge the tax from the date you filed that late return.
Example: You owe for 2002 (hence, Due date was Apr 15, 2003 satisfying the 3 year rule), but you did not actually file the 2002 1040 until April of 2006. That IRS debt can be discharged NOW because you filed the return more than 2 years ago and the due date of the return satisfies the 3 year rule.

3. The 8 month audit rule: If you are audited and ADDITIONAL tax is assessed, you must wait 8 months before you can file a BK petition to discharge that additional tax.

4. The fraud rule: The IRS can challenge the discharge of tax debt if you committed any sort of fraud. Keep in mind, BK fraud is less strenuous than regular fraud in that the creditor normally need not prove "actual" intent.