Most people believe taxes cannot be discharged in bankruptcy. This is false. Bankruptcy is one of the most effective and powerful legal tools a taxpayer can use to eliminate tax debt. This does not mean all taxes are dischargeable in bankruptcy.
For example, a business owner who did not pay the trust fund portion of payroll taxes cannot discharge that tax debt in bankruptcy. Trust fund taxes are those taxes withheld from an employee’s paycheck. However, the matching portion of the trust fund taxes the employer is supposed to pay to the taxing authorities may be discharged in bankruptcy.
There is a 3-prong test we use for the initial evaluation of determining tax dischargeability
The first prong requires that the tax must have been due at least 3-years prior to the bankruptcy filing date. Remember, tax returns for the prior year are usually due by April 15th of the following year. For example, 2022 taxable year returns are not due until April 15th of 2023. Extensions will change the due date and must be considered in this analysis.
The second prong requires that the tax return be filed within 2-years of the bankruptcy filing date. Some jurisdictions will honor dischargeability of taxes even if the return was filed late, as long as the IRS has not filed a substitute for return (SFR). However, not all circuits follow the same rules. Therefore, dischargeability results must be analyzed under the law for the circuit in which the debtor files the bankruptcy case.
The final prong requires that at least 240-days have passed since the IRS assessed the tax debt. Tax assessments generally mean the date the IRS determines there is a liability owed. If a taxpayer meets the 3-prong test they have a good chance of discharging those taxes.
However, there are many exceptions left to analyze such as tolling events caused by filing an offer in compromise, or while a prior bankruptcy was pending, or whether there are properly recorded tax liens, or there was fraud or a tax evasion scheme. If tax debt is owed, the bankruptcy should not be filed prior to an analysis of the dischargeability of the taxes has been completed.
Tax analysis fees generally run between $1,500 – $5,500 depending on the complexity of the matter, the number of years to be analyzed, the amount of tax owed, and whether there were numerous tolling events to calculate. A tax analysis opinion is a small price to pay to eliminate a large tax debt.
Determining the dischargeability of tax debt should be done only by a Certified Bankruptcy Specialist with the requisite experience to do so or by a Tax Attorney. The only way to conduct the proper analysis is for the tax attorney to obtain the taxpayers tax transcripts from the IRS. If your bankruptcy is filed one day too soon, you could miss out on eliminating thousands in tax debt. Do not skip the crucial step of hiring competent counsel to provide a tax analysis opinion.
I earned my LLM (Masters of Laws) degree in Taxation from the University of San Diego School of Law. My bankruptcy experience coupled with my Taxation LLM provides me with the requisite experience to assist my clients and colleagues nationwide in tax related bankruptcy matters.
Though this blog focuses on IRS tax debt. However, the state taxing authorities, such as the California Franchise Tax Board, the California Employment Development Department, and the California Department of Tax and Fee Administration usually follow the IRS in dischargeability matters, meaning of the taxpayer meets the same prongs for the state tax debt owed, it will likely be discharged as well.
Author: Jenny L. Doling, Esq., LLM Taxation
CA State Bar Certified Bankruptcy Specialist
Secretary and Board of Director of NACBA
President of the San Diego Bankruptcy Forum
Serving Bankruptcy Clients throughout California and
Tax Clients Nationally