Are Tax Debts Dischargeable In A Bankruptcy?

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1. Trust Fund Taxes Are Never Dischargeable

   In bankruptcy, we make a distinction between trust fund taxes and non-trust fund taxes. Trust fund taxes are never dischargeable in bankruptcy. The quintessential example of a trust fund tax is a payroll tax. When an employer has employees and pays them, prior to giving the employee the paycheck, the employer is supposed to take out taxes and send them to the taxing authorities. The employer never owns that money; the employer holds it in trust for the taxing authorities. If the employer doesn’t send the money to the taxing authorities, it has breached that trust. That kind of a debt can never be discharged. It is a violation of a sacred trust between the employer and the taxing authorities. That type of failure to pay taxes can result in criminal prosecution, which can lead to imprisonment.

2. Income Taxes Must Satisfy Three Requirements For Dischargeability

Most of the taxes involved in bankruptcy are income taxes. In certain circumstances, income taxes can be discharged in bankruptcy. The general rule is that the income tax debt has to satisfy three requirements.

All three requirements must be satisfied. If you’re off by even one day on any of them, the tax debt will not be discharged. There is no mercy.

1. The Three-Year Rule

The first requirement is referred to as the three-year rule. It says that if you are going to discharge your tax debt for a given tax year, then the return for that tax year must have been due, with extensions if you got them, at least three years before the day you file a bankruptcy petition.

2. The Two-Year Rule

The second requirement is the two-year rule. The two-year rule focuses on whether or not you filed a return. You must have filed a legitimate non-fraudulent return for the given tax year at least two years before the day you filed the bankruptcy petition.

3. The 240-Day Rule

The third requirement is the 240-day rule. The 240-day rule says that the tax debt you are trying to discharge cannot have been assessed, or have been assessable, during the 240-day window immediately prior to the day you file the bankruptcy petition.

3. Tax Transcripts From The IRS

If the tax is owed to the IRS, you won’t know when the tax was assessed without getting the tax transcript. There are different types of transcripts. The type used to do the tax dischargeability analysis is called an account transcript. It gives a chronological taxpayer history for your social security number for that given tax year.

1. The Three-Year Rule

For the three-year rule, you should go to the IRS’s website (www.irs.gov) and look up when the return was due. This is because in some years the return isn’t due until April 16 or 17 (because of holidays). In addition, you might have gotten an automatic extension, which pushed the filing date out.

2. The Two-Year Rule

The account transcript will have the date you filed the return, so you can use it to determine whether the two-year rule has been satisfied.

3. The 240-Day Rule

The transcript will list the date of the last assessment. Add 241 days to that date to get a possible bankruptcy filing date.

4. The FTB’s Prebankruptcy Letter

The same rules apply to state taxes. Unfortunately, the FTB stopped issuing transcripts years ago. However, upon request they will issue a prebankruptcy letter, that can be used to do the analysis.

There are a few additional wrinkles.

5. The Bankruptcy Code’s Tolling Provisions

There are some tolling statutes in the Bankruptcy Code. They apply to the three-year, two-year, and 240-day rules. To illustrate them, let’s consider their application to the 240-day rule.

1. Tolling As A Result Of An Offer In Compromise

Suppose you entered an offer in compromise when the 240-day clock had reached 225 days. At that point, the clock stopped. It stays stopped until the offer terminates. After termination, the clock restarts. If you think that all you have to do is wait the additional fifteen days to reach day 240, you are mistaken. According to the Bankruptcy Code, at the end of the 240-day window you have to add an additional 30 days before satisfying the 240-day requirement.

2. Tolling During A Prior Bankruptcy Case

If you were in a prior bankruptcy case, when you filed the petition the clock stopped. After termination of the case, the clock restarts. This time, after you have reached day 240 you have to add an additional 90 days before filing the bankruptcy petition.

6. A Substitute For Return

If you don’t get around to filing your return, the IRS will file one on your behalf. That kind of a tax return is called a substitute for return. If the IRS files a substitute for return for a given year, the tax debt for that year is never dischargeable in most federal circuits, including the Ninth Circuit.

In sum, if you satisfy all of the requirements, you can discharge a tax debt in bankruptcy. However, the analysis is complicated, so you should retain a competent bankruptcy attorney to do the analysis for you. If you get it wrong, you’ll go through the bankruptcy and still have all that tax debt.

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