There are many administrative tactics that taxpayers can use to reduce or eliminate their outstanding tax debt. They can enter into an installment plan with the IRS or the state revenue agency to make payments over an extended period of time to avoid offsets. The taxpayer could also make an offer-in-compromise to settle the total debt for less than what is actually owed. The taxpayer may even request a collection due process hearing or seek the assistance of the National Taxpayer Advocate’s Office if other administrative measures fail. As a last resort, if the debt is simply too crushing and all other choices are exhausted, the taxpayer may consider filing for Chapter 7 bankruptcy.
Chapter 7 bankruptcy is known as the “liquidation bankruptcy” because it has the effect of discharging much of your unsecured debt such as credit cards, medical bills and personal loans not tied to collateral. This is distinct from a Chapter 11 or Chapter 13 bankruptcy where the debtor applies to reorganize and restructure debt under a payment plan. Bankruptcy is an extreme remedy as it can only be used once every seven years and that it will leave a significant notation on your criminal record. In addition, the petitioner for bankruptcy will lose money and property to settle debt while being able to retain some assets allowed under law. However, it may be the reset button that most people need to start over and get a fresh start.
Can tax debt be discharged in bankruptcy? It is true that some tax debt can be discharged, but you must first understand there are certain taxes that will not. The United States Bankruptcy Code provides that certain taxes are considered “priority debts” and can NEVER be discharged in Chapter 7 bankruptcy. 11 U.S.C. §523(a)(1)(A). These priority tax debts include the following:
- Any taxes based on income or gross receipts if ANY of the following grounds are met:
- The tax return for the tax is last due, including any extensions, DURING THE LAST THREE YEARS BEFORE the petition was filed. This date is the date that the return is due, not when it was actually filed. 11 U.S.C. §507(a)(8)(A)(i).
- The income tax was ASSESSED within 240 DAYS AFTER THE ASSESSMENT. 11 U.S.C. §507(a)(8)(A)(ii). However, if there was an offer-in-compromise made during this time by the taxpayer, then this 240-day period is extended by the time that the IRS was considering the offer plus 30 days. 11 U.S.C. §507(a)(8)(A)(ii)(I). In addition, if there was a stay of proceedings by the IRS with respect to any collections on those taxes, then this 240-day period is extended by the time that the proceedings were stayed plus 90 days. 11 U.S.C. §507(a)(8)(A)(ii)(II).
- The tax was still subject to audit as of the petition date. For example, most federal income taxes are subject to audit within three years after the tax return was due (or six years if the taxpayer understated his gross income by 25%). If the taxpayer never filed a tax return, then there is no statute of limitations on when the audit can be assessed. The State of Michigan has a four-year period to initiate an audit after the return was due. 11 U.S.C. §507(a)(8)(A)(iii).
- IF THE TAX BASED ON INCOME OR GROSS RECEIPTS HAD A RETURN DUE DATE OVER THREE YEARS AGO, WAS ASSESSED MORE THAN 240 DAYS AGO AND IS NO LONGER SUBJECT TO AUDIT, IT IS A NON-PRIORITY DEBT AND MAY BE DISCHARGEABLE.
- Any state or local property taxes that were DUE WITHIN THE ONE YEAR PERIOD BEFORE THE PETITION WAS FILED. 11 U.S.C. §507(a)(8)(B). IF THE PROPERTY TAX WAS DUE MORE THAN ONE YEAR AGO, IT IS A NON-PRIORITY DEBT AND MAY BE DISCHARGEABLE.
- Employment taxes where the return was DURING THE LAST THREE YEARS BEFORE the petition date. 11 U.S.C. §507(a)(8)(D). However, any withholding or payroll taxes are NOT dischargeable. OTHER EMPLOYMENT TAXES DUE MORE THAN THREE YEARS AGO ARE A NON-PRIORITY DEBT AND MAY BE DISCHARGEABLE.
- An excise tax on a transaction for which a return was last due DURING THE LAST THREE YEARS BEFORE the petition was filed. This date is the date that the return is due, not when it was actually filed. 11 U.S.C. §507(a)(8)(E)(i). If no return was due, then it applies to any excise tax where the transaction occurred DURING THE LAST THREE YEARS BEFORE the petition was filed. 11 U.S.C. §507(a)(8)(E)(ii). IF THE EXCISE TAX WAS DUE MORE THAN THREE YEARS AGO, IT IS A NON-PRIORITY DEBT AND MAY BE DISCHARGEABLE.
- ANY penalties related to any priority tax debts under the Bankruptcy Code. 11 U.S.C. §507(a)(8)(G).
In addition to these priority debts, certain other types of taxes such as the trust fund penalty under 26 U.S.C. §6672 and most state sales taxes are NEVER dischargeable.
If your tax is not a priority tax under one of these categories, then it may be dischargeable in Chapter 7 Bankruptcy. However, the tax must satisfy ALL THREE ADDITIONAL REQUIREMENTS:
- If a return was due for the tax, it must be filed or the tax can NEVER be discharged. 11 U.S.C. 523(a)(1)(B)(i).
- If a return was due for the tax and it was filed AFTER THE DUE DATE, then AT LEAST TWO YEARS must pass from the date the return was filed before the bankruptcy petition was filed. 11 U.S.C. §523(a)(1)(B)(ii).
- If the taxpayer “made a fraudulent return or willfully attempted in any manner to evade or defeat such tax”, then a discharge will not be granted with respect to the tax. 11 U.S.C. §523(a)(1)(C).
If your tax debt meets all of the criteria above, then it may be eligible for discharge in a Chapter 7 bankruptcy. When a petitioner files for bankruptcy, he or she receives the benefit of an “automatic stay” which means that nearly all creditors have to cease their collection efforts while the bankruptcy is pending. This automatic stay applies to tax collecting entities such as the Internal Revenue Service or the Michigan Department of Treasury which must cease any set-offs, seizures and levies until the bankruptcy is resolved. This stay can provide some breathing room for a period of time while the taxpayer gets his affairs in order. However, if the bankruptcy is resolved or dismissed and there are tax debts remaining that were not discharged, then the IRS and any state collecting agencies can resume collection activities.
One unintended consequence of bankruptcy is that it will give the IRS more time to collect on tax debt that was not discharged. Generally, the Internal Revenue Service may collect taxes due by levy or court proceeding, “but only if the levy is made or the proceeding begun within 10 years after the assessment of the tax.” 26 U.S.C. §6502(a)(1). However, the Internal Revenue Code has many provisions that can extend the “collection statute expiration date” (CSED) long after the ten-year period has expired. For example, the period of limitations for IRS collection is suspended for the period during which the taxpayer enjoys an automatic stay from all collection efforts by filing bankruptcy AND for 6 months afterwards. 26 U.S.C. §6503(h)(2). The average bankruptcy case may take up to six months to resolve. This means that, if the taxpayer filed for bankruptcy and left a tax debt that wasn’t discharged, the IRS will have the statutory 10 years plus six months for the automatic stay plus six months following case closure for a total of 11 years (assuming no other statutory extensions apply). A bankruptcy that is unsuccessful in eliminating tax debt can give the revenue agency more time to levy and seize money and property to satisfy the obligation.
Before considering if bankruptcy is an option to resolve your tax debt, you can benefit from the advice and guidance of a skilled tax lawyer. If you have questions about federal taxation or need legal representation, do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.