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The dischargeability of taxes in bankruptcy is a very complex topic. However, many clients are surprised to learn that under certain circumstances, income tax debt can be discharged in bankruptcy.

When can income taxes be discharged in bankruptcy?

An individual’s income tax liability for any particular tax year is dischargeable in bankruptcy if ALL the following apply:

  1. A “return” was filed. (A “substitute for return” filed by the IRS is not considered a return).
  2. The return was actually filed more than 2 years prior to filing bankruptcy.
  3. The return was due (with extensions) more than 3 years prior to filing bankruptcy.
  4. Taxes were assessed more than 240 days prior to filing bankruptcy.
  5. No fraud or willful evasion exists.

The waiting periods to qualify tax liabilities for dischargeability in bankruptcy do not begin to run until the client files the tax returns. It is counter-productive to put one’s head in the sand to avoid filing tax returns. It will prolong the time a client will have to wait to obtain the discharge of potentially large tax liabilities.

Even if tax liabilities result from filing a return, the IRS has many consumer-friendly payment plan options that do not affect the waiting periods to discharge the tax debt. A payment plan may be necessary while weighing bankruptcy options.

Chapter 7 income limitations do not apply in “non-consumer” cases. A “non-consumer” case is one in which more than half of the client’s debt is essentially business related. Tax debt is considered “non-consumer” in nature. Therefore, even high income earners may qualify for a “non-consumer” Chapter 7 bankruptcy to discharge unlimited amounts of qualifying income tax liability.

Even if a client cannot discharge tax debt in a Chapter 7 (such as liability from recent years), a Chapter 13 reorganization can be used to allow orderly payment of the tax debt while discharging other dischargeable debts.

Sometimes the IRS files tax liens. Liens generally pass through bankruptcy unaffected.  This means that although bankruptcy will discharge a debtor’s personal liability for the tax debt, the lien will remain. But the lien only attaches to property of the debtor that existed when the bankruptcy petition was filed. The IRS is then able to sell certain property to satisfy its lien. It is therefore best to weigh all bankruptcy options before a tax lien is filed.