The Requirements to Abate Taxes in Bankruptcy

Generally, in a bankruptcy proceeding the debtor’s pre-petition debts are discharged; taxes are unique in that most tax debts are not dischargeable. However, some tax debts may be dischargeable depending on the type of tax, how old the tax debt is, if the debtor filed a return, and the type of bankruptcy. Although, it is more likely to receive a tax debt discharge in a Chapter 7 liquidation bankruptcy, than in a Chapter 13 bankruptcy with a repayment plan. In a typical individual debtor Chapter 7 bankruptcy, certain types of federal income taxes can be discharged if the debtor can meet several requirements.

The first requirement is that the discharge will be only for income taxes and not payroll taxes or penalties for fraud. 11 U.S.C. § 523(a)(14),(14A),(14B); § 507(a)(4)(A). This provision helps protect employees due a paycheck that was earned 180 days prior to the debtor’s petition filing. It also reinforces the Bankruptcy Code’s general principle that any debt that was obtained through fraud or fraudulent means will not be dischargeable.

The second requirement for a tax debt to be discharged is that the debtor filed a legitimate tax return for the relevant tax years at least two years before filing for bankruptcy. This provision is consistent with the general requirement that the debtor has acted in good faith regarding its taxes.

The third requirement is that the tax liability debt is at least three years old, meaning that the tax return was originally due at least three years before the debtor filed for bankruptcy. § 507(a)(8)(A)(i); See In re Turner 182 B.R. 317 (Bankr. N.D. Al. 1995) (where a debtor’s tax liabilities were discharged, which were at least three years prior to debtor’s petition filing). This can be seen as a public policy provision to help debtors get a fresh start with tax debts older than three years, another general policy objective of the Bankruptcy Code.

The fourth requirement is that the debtor is eligible for the 240-day rule. This means that the IRS assessed the tax debt 240 days (approximately 8 months) prior to the debtor’s bankruptcy filing. § 507(a)(8)(A)(ii)(I)-(II). Uniquely though, an assessment is not a prerequisite for the IRS to make a claim in the bankruptcy proceeding, so long as it is “assessable”. See U.S. v. Frontone, 383 F.3d 656 (7th Cir. 2004).

The fifth and sixth requirement are closely related in that one requires that the debtor did not commit willful tax evasion, and the other requires that the debtor did not commit tax fraud. Courts have held that possible evasive actions include changing your name, social security number, or the spelling of your name, as well as, filing a blank or incomplete tax return, or withdrawing any funds from a bank account and hiding it. For committing tax fraud, courts look at the tax return to see if it contains any information that was intended to defraud the IRS. See § 727(a)(2)-(5). Notably, the provisions in § 727(a)(2),(3),(4),(5) regarding fraudulently conduct and the like reach back one year prior to the petition filing, and continue throughout the bankruptcy proceedings if that conduct involves an insider. § 727(a)(7). Further, if a court denies a discharge under § 727, this will act as a global denial on all of debtor’s otherwise permissible discharges.

If a debtor can meet all six of these bankruptcy requirements regarding a tax debt, the debtor may be able to discharge that tax liability. Upon the discharge of a tax liability, the debtor is no longer responsible for paying the discharged taxes and most importantly the IRS cannot garnish the debtor’s wages or bank accounts. §§ 524(a)(1)-(3), 727(b).

Julie Camden of Camden & Meridew, P.C. practices in the areas of tax and bankruptcy law.  Julie has litigated various issues related to individual and corporate tax obligations.  Please contact our office at 317-770-0000 or complete our online contact form if you would like to explore the possible discharge of taxes in bankruptcy.

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