Can bankruptcy get you out of a bind with the IRS and eliminate your tax debt?
If this was a true or false law school exam, I would say that’s a trick question. The answer is both – bankruptcy can discharge tax debt, and it can’t.
There are many rules in the bankruptcy code that must be followed to have a tax debt discharged. And those rules make some taxes dischargeable, and some not. You can’t always just file bankruptcy and poof!, the IRS is gone. But if you know the bankruptcy discharge rules, and follow those rules before you jump in, then yes, bankruptcy can be a friend in solving your IRS problem.
Here it is a nutshell: Bankruptcy makes some debts easy to discharge, like credit cards and medical bills. This is because Congress does not consider those debts to be of a type where extra effort has to be exerted for a fresh start.
Congress gives the IRS a chance to collect unpaid taxes before they can be discharged in bankruptcy. That is different from, say credit cards, where there is no direct law giving credit card companies time to collect the debt before you can say bye-bye to them. Congress has also made some taxes – like unpaid payroll taxes, or tax fraud – never dischargeable in bankruptcy.
Sometimes, you are ready to file bankruptcy and we determine that the time the IRS is allotted to collect has already expired, and you can immediately file bankruptcy and be done with your taxes, whether the IRS likes it or not.
Other times, we may have to put the IRS on hold and buy a little bit of time to get your bankruptcy filed so your taxes can be eliminated.
And there may be times where your taxes cannot be discharged in bankruptcy no matter how long you wait to file, such as when you owe employment taxes, have tax fraud, or your debt is the result of an IRS substitute for return.
Here, then, are the rules to making the IRS go away with bankruptcy.
First, the timing rules – how old must your tax debt be to wipe out the IRS in bankruptcy – there are three main rules to follow:
1. Three Year Rule. Your bankruptcy must be filed at least three years after your tax return was due to filed with the IRS, including extensions.
Example: You owe the IRS for 2010 taxes. Your 2010 tax return was due to be filed with the IRS on April 15, 2011. Your tax debt is eligible for bankruptcy after April 15, 2014.
2. Two Year Rule. Your bankruptcy must be file at least two years after your tax return was actually filed.
Example: You owe the IRS for 2010 taxes. You filed the return late – on June 1, 2013. Your debt is eligible for bankruptcy after June 1, 2015.
3. 240 Day Rule (usually, eliminating tax debts from an IRS audit). Your bankruptcy must be filed at least 240 days after the IRS puts the balance you owe on its books (called an assessment). This rule usually applies in audit scenarios, when the IRS finds you owe them money after your return has been filed. After the audit is complete and the IRS puts the money owed on its books, you have to wait 240 days to file the bankruptcy.
Example: Your 2010 tax return was due on April 15, 2011, and filed on time. The IRS then audited you, with audit completed and tax owed put on the IRS’ books on February 1, 2014 (assessment). Your tax debt is eligible for bankruptcy on October 1, 2014, which is 240 days after the audit assessment was made, and more than three years since the return was filed.
All three of these rules – the Three Year Rule, the Two Year Rule, and the 240 Day Rule – must be met before you file bankruptcy.
But be careful – there are traps to avoid on the way to beating the tax bankruptcy timing rules. Avoid these actions, which can extend the timing rules: