Bankruptcy and Income Taxes

Bankruptcy, in several instances,  can be an effective way of dealing with past due federal and state income tax debt.

In a Chapter 7 or Chapter 13 bankruptcy income tax obligations are dischargeable if the tax return for the year in question was filed and:

(1)  The 3 Year Rule: The tax return was due more than 3 years prior to the bankruptcy filing. If the debtor obtained an extension, the due date would be the extension deadline

(2)  The 2 Year Rule: For a late filed return (filed after its due date and any extensions), if the delinquent return was actually filed more than 2 years prior to the bankruptcy filing

(3)  The 240 Day Rule: If there has been an assessment by a taxing authority, it was made more than 240 days prior to the bankruptcy filing

(4)  The debtor did not file a fraudulent return or willfully attempt to evade paying taxes.

Example #1 - Debtor timely filed their 2003 tax return (due on April 15, 2004).  There have been no recent assessments by the government and the return was not fraudulent. The taxes still owed from the 2003 return are dischargeable if the bankruptcy is filed after April 15, 2007 (“the 3 Year Rule”). 

Example #2 - Debtor files their 2001 tax return late, on October 31, 2005. There have been no recent assessments, and the return was not fraudulent. The taxes still owed from the late filed return are dischargeable if the bankruptcy is filed after October 31, 2007 (the “2 Year Rule”).

 “Trust fund” taxes, such as payroll withholding and social security withholding by an employer and sales taxes are never dischargeable in Chapter 7, and are dischargeable in Chapter 13 only if paid in full over the life of the Chapter 13 Plan.

In Chapter 7 if the underlying tax obligation is dischargeable, the interest and penalties thereon are also dischargeable. However, if the underlying obligation is non-dischargeable, so are the related interest and penalties.

Tax liens are not discharged in Chapter 7 even if the tax obligation that forms the basis of the lien is dischargeable. However, the remaining lien from a dischargeable tax obligation will only be enforceable against assets owned by debtor at the time of the bankruptcy filing, and only to the extent of the assets’ value . This is very important because if the underlying tax obligation is discharged, the remaining lien will not attach to any assets acquired by the debtor after the bankruptcy filing.

In Chapter 13, claims for priority taxes (ie. do not meet the “3 Year Rule”) and secured taxes (tax liens filed) must be paid in full; however, secured claims are only paid in full up to the value of debtor’s assets. Your attorney can bring an application under Section 506(a) to determine what portion of the secured claim must be paid in full. The balance of the “unsecured portion” will be paid with the rest of the unsecured claims, often for a fraction of its full value.

In addition to eliminating the "Chapter 13" super-discharge that existed under prior law, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (hereafter referred to as " BAPCPA"} made other tax-related changes, particularly concerning Chapter 13.  BAPCPA requires a Chapter 13 debtor to file tax returns for the four taxable years preceding the bankruptcy filing no later than the day before the first scheduled Section 341 Meeting of Creditors.   A debtor who fails to file these required tax returns  cannot have his Chapter 13 Plan confirmed by the Court,  and his case is subject to dismissal.

Under BAPCPA  there are more instances where tax refunds can be intercepted by interested parties.  The automatic stay created by the bankruptcy filing no longer prevents the interception of tax refunds for payment of a domestic support obligation  (ie., past due child support),  and  it no longer prevents taxing authorities from exercising  setoffs  against tax refunds (ie., taking your refund}  for prepetition tax periods to cover prepetition tax debt.

Many tax liabilities can be successfully dealt with in both Chapter 7 and Chapter 13, and an experienced bankruptcy attorney can be of immeasurable assistance in this very tricky area. 

Bankrupcy lawyers with offices in Middletown, New York serving Orange, Sullivan, Ulster and Dutchess Counties and communities including Newburgh, Port Jervis, Goshen, Monticello, Liberty, Ellenville, New Paltz, Kingston and Poughkeepsie.

This Law Firm proudly practices Bankruptcy Law, helping clients file cases under Chapters 7 and 13.  According to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, we are considered to be a Debt Relief Agency.