A great question from a reader about discharging taxes when successive bankruptcies are filed:
Mr. Levy – I hope you can help me. I owe back taxes and filed a Chapter 13 to repay the IRS. The Chapter 13 was dismissed because I could not keep up with the payments. Now I would like to file a Chapter 7 to eliminate what I did not pay. My attorney mentioned something about a stopwatch while I was in the Chapter 13. What is this all about?
You are correct in recognizing that eliminating taxes in bankruptcy is all about timing - keeping an eye on the “stopwatch.” You are referring to the requirement that taxes can be discharged in bankruptcy only if your return was due to be filed at least three years before your bankruptcy started and was actually filed at least two years before your bankruptcy.
But if you file a bankruptcy before these timing rules are met (like you apparently did with your Chapter 13), does the “discharge clock” keep ticking? Are taxes that were not eligible for a tax discharge when you entered the Chapter 13 now eligible when you come out of it and want to file a Chapter 7? Was time on your side?
The U.S. Supreme Court resolved this issue in 2002 in the case of Young v. U.S., 535 U.S. 43. In that case, Cornelius and Suzanne Young filed a Chapter 13 bankruptcy to try to repay their debts, including $13,000 to the IRS. The Chapter 13 was filed before the tax discharge timing rules were met.
Unable to make their bankruptcy payments, the Youngs dismissed their Chapter 13 and filed a Chapter 7 instead. By the time the Youngs had filed their Chapter 7, the taxes had aged to the point of being old enough for a discharge under the bankruptcy tax timing rules.
The IRS argued that the bankruptcy discharge rules were “tolled” during the Young’s Chapter 13. The government also argued that since it was prevented from collecting during the Chapter 13, the tax discharge stopwatch should be treated the same way – tolled.
The court agreed with the IRS, recognizing that any other ruling would create a loophole for taxpayers - filing a Chapter 13, getting time on the discharge rules without any risk of collection, and then filing a Chapter 7 when the time was right.
The prior Chapter 13 never happened for purposes of bankruptcy discharge timing rules.
In 2005, Congress codified the Supreme Court’s ruling in Young – see Bankruptcy Code 507(a)(8)(a)(i) - and added an additional 90 days to the tolling period.
Summary: If you filed a Chapter 13 too early to eliminate your taxes, had it dismissed and now want to try a Chapter 7, ou cannot add in the time the Chapter 13 was pending to your tax discharge calculations.