Discharging Unpaid Income Taxes in Bankruptcy – Some Now, Some Later, Some Never
There is no moratorium keeping the IRS and FTB from enforcing tax obligations against the taxpayer’s assets. Is bankruptcy a possible solution for one who has accumulated unpaid income tax debt?
For the taxing agencies, it’s collection as usual, regardless of Covid.
Various moratoria, and the on-again, off-again status of the courts, have eased the traditional pressures on cash-strapped individuals and businesses. The one class of players, however, which are not subject to any moratoria, are the federal and state taxing agencies. Their broad-based collection activities continue unabated, regardless of Covid.
Note: since the principal amount of taxes, as well as applicable penalties and interest are treated the same in nearly all instances in the bankruptcy process, all references to “unpaid income taxes” will include penalties and interest.
The gross-payroll trap
Let’s consider for a moment where much individual tax debt comes from. Many small business owners use “IRS financing” to maximize what they receive from the business by simply not withholding federal and state income and self-employment taxes, and paying themselves the gross payroll amount. “I’ll pay it when the business takes off”. It isn’t too many years before unpaid income taxes are well into the six figures. It happens very quickly.
This is followed by IRS notices and threatening letters, which, more often than not, are followed by an installment agreement with the IRS. A band aid, at best.
Often this spiral of tax debt increases steadily over time with more gross payrolls without withholding, more IRS notices and letters, and more installment agreements until the taxpayer realizes that the payments are going up faster then his income, and the principal balance of the taxes is not going down appreciably. Penalties and interest continue to accrue.
Others have unpaid income taxes “thrust upon them” through assessments, often following audits. Still others have relied on others, such as business managers, to properly provide for the payment of taxes, only to find out that the manager “managed” their way through the funds without providing for the income tax liabilities. Professional athletes and entertainers are sometimes on the receiving end of such treatment, with disastrous results. .
At some point the issue becomes what to do with unpaid taxes, penalties, and interest, now that is clear that it cannot be serviced. Often it is in the face of an IRS bank account levy, which is not limited as to amount or frequency. At that point, harried taxpayers often turn to the bankruptcy system.
Discharging unpaid income taxes through bankruptcy
Is bankruptcy an answer for the crushing burden of unpaid income taxes? The answers are yes, no, and maybe. The good news is that the bankruptcy system does provide for the discharge of some income taxes. These are for the most part unpaid taxes that could be described as “old”.
Major caveat: This article deals in a very general manner with a VERY complex and nuanced topic, the discharge of unpaid income taxes through bankruptcy. Nothing in this article is meant as legal advice to anyone in any situation. Persons with unserviceable income tax debt should consult with an attorney (not an accountant) who practices in the area of discharging taxes in bankruptcy, which is a bonafide subspecialty.
To determine whether unpaid income taxes are dischargeable in bankruptcy, each tax year must be analyzed using three separate tests. The three tests are very briefly described as follows:
- The 3-year test. The deadline for filing the tax return for the year in question, including extensions, must have been more than three years before the filing of the petition initiating the bankruptcy case (the “Petition Date”).
- The 2-year test. The tax return for the year in question must have been filed more than two years before the Petition Date.
- The 240-day test. More than 240 days, plus an additional 30 days, must have passed between the assessment of any additional taxes, and the Petition Date. The 240 + 30-day period ceases running during any time when an offer-in-compromise is pending, or any time when the taxpayer was in a previous bankruptcy case.
The above is the short form, but it gives you the idea.
Taxes from late-filed returns
What about taxes resulting from returns that were filed after the filing deadline, even after extensions? The majority of courts have held that late-filed returns do not constitute “returns” for the purpose of the 2-year rule, and thus the 2-year rule can never be met. Let that sink in for a moment: Taxes for years in which the return was filed late can never be discharged. That’s very serious. Needless to say, there are great efforts being made to convince those courts which hold to the “late-filed return is not a return” rule to reverse field, or to have the matter resolved by the United States Supreme Court. The Ninth Circuit Court of appeals, whose decisions are binding on bankruptcy courts in California, is one of the majority of circuits which hold that a late-filed return is not a return. The ins and outs of this issue may be the subject of another article
How the discharge of the underlying taxes affects recorded tax liens.
What about taxes which are secured by a recorded tax lien? Even if the underlying taxes are discharged, the lien remains. The issue often arises post-bankruptcy when the taxpayer/debtor wants to sell a residence that was claimed exempt in bankruptcy. The tax lien remains as an encumbrance on the property and the taxes must be paid at closing. The discharge of the underlying taxes prohibits the IRS and FTB from enforcing their lien against personal property (levies, garnishments, etc.), but the recorded lien against real property survives bankruptcy. The endgame, if the tax amount is large, is to wait out the IRS, since, after 10 years, tax liens expire unless renewed by a formal filing by the IRS or FTB. The filing of a renewal, however, is prohibited by the bankruptcy discharge as an act to enforce a pre-bankruptcy claim. See, 11 U.S.C. § 524. At that point the tax lien has timed out and is no longer an encumbrance of the real property.
Some taxes are never dischargeable, ever
The IRS has a process through which an officer, director or manager of a corporation or limited liability company can be designated as a “responsible person”. If such a finding is made, then the responsible person becomes personally liable for the “trust fund” payroll tax obligations which accrued on the person’s watch. The trust fund taxes are those payroll taxes which were shown as withheld on employees’ pay-stubs and W-2s, but for which the funds were never remitted to the taxing agency. Responsible person liability for trust-fund taxes is never dischargeable, ever.
Similarly, the IRS, after investigation, can make a formal finding that a return was fraudulent. The liability for taxes owed through the filing of a fraudulent return are also never dischargeable.
Timing is everything
The determination of whether tax unpaid taxes are dischargeable in bankruptcy is mainly a time-based analysis, so long as the taxes are not part of the never-dischargeable classification mentioned above. Thus, if unpaid income taxes meet all three tests for all years in question, then a bankruptcy case can probably be filed. If sufficient time has not passed, then a calculation of the earliest date in which sufficient time will have run so that all three tests are met is done and the taxpayer waits. Filing before the time regarding all three tests has run results in the tax claims being unaffected by the bankruptcy – not the intended result.
If the taxing body is being particularly troublesome, and the taxes which do not yet qualify for a discharge are of a relatively small amount, and the larger amounts are dischargeable, a decision may be made to file the case, which has the effect of staying any further enforcement by the taxing agencies for any year, knowing that some of the years will not be discharged, and will remain payable after the conclusion of the bankruptcy case.
It cannot be over-emphasized that the discharge of unpaid income taxes, penalties and interest in bankruptcy is a complex topic and should only be undertaken by an attorney with experience in such cases. This article sets out the general parameters, but how specific taxes are treated in bankruptcy requires an analysis by a qualified attorney with experience in the area. If handled properly, the bankruptcy process can free the taxpayer of unserviceable tax debt, that in some cases can be well into the hundreds of thousands, if not millions of dollars.
David Reeder has substantial experience in advising clients regarding the dischargeability of unpaid income taxes in bankruptcy, and representing taxpayers in bankruptcy cases in which the discharge of unpaid income taxes a goal.