Law Offices of Nicholas Gebelt

Are Taxes Dischargeable In A Chapter 13 Bankruptcy?

In order for a tax debt to be dischargeable in any chapter, and in particular, in a Chapter 13, it has to satisfy three requirements. All three must be satisfied. If you’re even one day off, you lose.

The first requirement is called the three-year rule. It says that the tax return for the given tax period (whether it’s a year, as with an income tax, or a quarter, as with sales tax) must have been due — with extensions if you got them — at least three years before the day you file the bankruptcy petition. For example, let’s say you are trying to get rid of 2018 income tax debt. How do we apply the three-year rule? The 2018 income tax return is due on April 15, 2019, so three years is April 15, 2022. That means you’d have to wait until April 15, 2022 to satisfy this first requirement for discharging a 2018 tax debt.

The second requirement is called the two-year rule. It says that you must have filed a legitimate, non-fraudulent tax return for the given tax year at least two years before the day you file the bankruptcy papers. Notice the difference between the three-year rule and the two-year rule. The three-year rule asks, “When was the return due?” The two-year rule asks, “When did you actually file the return?”

Finally, the third requirement is called the 240-day rule. It says that the tax you’re seeking to discharge cannot have been assessed by the taxing authority during the 240-day window immediately prior to the day that you file the bankruptcy papers. Since 8 x 3 = 24, 8 x 30 = 240. Therefore, the 240-day window is eight 30-day months.

Before you breathe a sigh of relief, there is an additional wrinkle.

If you had a prior bankruptcy case pending during one of those three time windows, the moment you file the bankruptcy case stops that clock. Once your bankruptcy case is closed—either because it was dismissed or because you got a discharge—that clock starts up again, but then you have to add 90 days at the end of the clock. The same applies for situations where you have an offer in compromise with the taxing authority: once you submit the offer, that stops the clock, and then once the offer is over—whether it’s because you satisfied the requirements of the offer, or because it was rejected—then the clock starts up again, but in this case with an additional 30 days added.

Here’s an additional wrinkle: If the taxing authority files a return on your behalf because you never got around to filing the return, then that tax debt is never dischargeable in bankruptcy in the Ninth Circuit.

So far, we’ve covered income tax and sales tax. There is another type of tax that creates an insurmountable hurdle in bankruptcy: Trust fund taxes. Trust fund taxes are never dischargeable in bankruptcy. The most common type of trust fund tax is a payroll tax.

Suppose you have employees. Before you give them their paychecks, you take out taxes that you’re supposed to send, on behalf of the employees, to the appropriate taxing authority, either the IRS or the California Franchise Tax Board. When you take that money out of your employees’ pay, it is not your money — ever. You are holding that money in trust for the taxing authority. If you fail to send the money to the taxing authority, you have violated that trust. You now owe that money to the taxing authority as a trust fund tax. That debt is never dischargeable in bankruptcy. And you’d better make provision to pay it, either in a Chapter 13 or Chapter 11 bankruptcy, or outside of bankruptcy. If you fail to pay it, you may end up living rent-free at government expense.

If the debt is to the IRS, then the good news is you will be in a federal penitentiary rather than a state penitentiary. I say on good authority that the food is better in the federal penitentiary. Some of my former bankruptcy clients who spent time in both types of penitentiaries before becoming my clients have assured me that the food is better in the federal penitentiaries. But why not simply take my clients at their word, and never experience it first-hand. Pay the trust fund debt in a bankruptcy.

Though we’re exploring Chapter 13, most people think of Chapter 7 (where the debt just gets wiped out, end of discussion, and you don’t pay a dime) when they think of debt discharge. Chapter 13 involves a multi-year debt repayment plan administered by the bankruptcy court, so what does it mean for a tax debt to be dischargeable in Chapter 13? It doesn’t mean that you’re never going to pay a dime on it. What it does mean is that the debt is treated just like general unsecured debt, such as credit card debt, medical bills, etc. The percentage that you’ll pay on the general unsecured debt is the percentage that you’re going to pay on that dischargeable tax debt. Then, at the completion of the plan (provided you do complete the plan), any remaining balance on that particular debt is discharged. A Chapter 13, therefore, means you’ll pay less than 100% (unless you have to be in a 100% plan), and the unpaid portion will be discharged at the completion of the plan.

In Chapter 13, there are a couple of ways to get your dischargeable tax debt discharged. One is to complete the plan, after which, you’ll get a discharge. The other is called a hardship discharge, which allows you to get a discharge without completing the plan.

A debtor can get a hardship discharge, after plan confirmation, as a result of a material change of circumstances that renders the debtor unable to make any plan payments, and when there’s no feasible way to modify the plan. The debtor must also have already paid back the general unsecured creditors at least as much as they would have received in a Chapter 7 liquidation. Furthermore, the change of circumstances cannot have been the fault of the debtor; in other words, the debtor can’t be justly held accountable for this change in circumstances.

If you’ve satisfied those requirements, then you can move the court to grant you a hardship discharge. Even if you haven’t paid much toward your tax debt, your dischargeable tax debt would still be wiped out in this situation. The nondischargeable tax debt, however, survives the hardship discharge. As you work to complete your plan in a Chapter 13, you have to pay the nondischargeable tax debt, typically referred to as priority tax debt, in full.

For more information on Tax Debts in California, a free 20 Minute Phone Strategy Session is your best next step. Get the information and legal answers you are seeking by calling (562) 777-9159 today.

Attorney Nicholas Gebelt

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