Tax season will soon be upon us. The April 15, 2016 deadline falls on a Friday. I am not a tax lawyer or an accountant. Often, when I meet with someone they are surprised when I tell them that their income tax debt may be discharged in a bankruptcy case. Accountants are also surprised to learn how income tax debt can be eliminated.
The laws are complex and vary in different parts of the United States. Timing is everything. Sometimes filing your bankruptcy case too soon can prevent a tax from being discharged. Sometimes you may not have a choice because of other circumstances such as a foreclosure sale threatening your home ownership. This may force a filing sooner than later.
The five basic rules for determining dischargeability sound simple, but they are not. Lawyers, bankruptcy judges and government tax agencies often disagree on how these rules should be applied. Every individual’s case is different. Here are the basic five rules and a short description of each one:
- IS THE TAX MORE THAN THREE YEARS OLD ON THE DATE THE BANKRUPTCY CASE IS FILED? Taxes owed prior to 2013 may be capable of being discharged if you have filed your tax returns on time and more than three years has gone by. Usually, I count from April 15 unless the date is later because the client has obtained an extension of the filing deadline. Late returns present special problems. Sometimes, a late return does not count as a return.
- WAS THE TAX RETURN FILED MORE THAN TWO YEARS BEFORE THE BANKRUPTCY IS FILED? The tax return MUST be filed for more than two years before the bankruptcy case is filed. If the IRS files a tax return for you (called a substitute for return), many bankruptcy judges have ruled that the tax is not capable of being discharged. This is why returns should always be filed even where you cannot pay the tax at the time the return is filed. The best move is to file the return on or before the day it is due.
- HAS THE TAX BEEN ASSESSED FOR MORE THAN 240 DAYS? While you may have filed your return on April 15 as required, the tax is not technically “assessed” until someone at the Internal Revenue Service reads the information in your tax return and decides whether to send you a bill for additional taxes you may owe. State tax authorities have different rules for when an income tax is considered to be assessed. In New Jersey, this is when the tax can no longer be administratively appealed by the taxpayer to the Division of Taxation and becomes “final.” You can find out the date your federal income tax was assessed by asking the Internal Revenue Service for a copy of your tax transcript. You do this by downloading and filing Form 4506T. Here is the link to the IRS’s web site: https://www.irs.gov/uac/About-Form-4506T
- THE RETURN MUST NOT BE FRAUDULENT. This means that the return was an honest effort by a tax payer to disclose all income and to take only lawful deductions. One example of a fraudulent return is understating income or hiding income. Another example is taking deductions to which you are not legally entitled.
- THE TAX PAYER MUST NOT BE GUILTY OF A WILLFUL ATTEMPT TO EVADE OR DEFEAT THE TAX. This might mean diverting income to a spouse, “significant other” or child. Another example might be destroying records.
All five of these basic rules must be satisfied in order for the tax to be discharged. Not being able to satisfy a bankruptcy judge that all five rules have been proven means the tax will not be discharged in bankruptcy. The tax payer will still owe the money to the tax collector.