Tax Troubles? How Bankruptcy Might Help You

Are you facing the daunting prospect of dealing with tax debts? You’re not alone. Many individuals find themselves in a financial bind due to unpaid taxes. The good news is that bankruptcy can sometimes provide a lifeline, helping you get a fresh start. In this blog post, we’ll explore the possibility of discharging income taxes in Chapter 7 and Chapter 13 bankruptcy, with some real-life examples to illustrate these concepts. Remember, though, this is for informational purposes only and not legal advice.

Understanding the Basics

Before we dive into real-life examples, it’s essential to grasp the basics of how tax discharge works in bankruptcy. Keep in mind that these rules generally apply to income taxes—other taxes, such as payroll taxes and most sales taxes, cannot be wiped out this way. In general, there are specific criteria that must be met for income tax debts to be dischargeable:

1. The Three-Year Rule: The tax return related to the debt must have been due at least three years before you filed for bankruptcy. This clock runs from the return’s due date, including any extensions—so April 15 of the year it was due, or October 15 if you filed an extension.
2. The Two-Year Rule: You must have actually filed the tax return at least two years before filing for bankruptcy. A substitute return prepared by the IRS on your behalf does not count.
3. The 240-Day Rule: The IRS must have assessed the tax debt at least 240 days before you file for bankruptcy.
4. No Fraud or Willful Evasion: The tax debt cannot be associated with a fraudulent return or a willful attempt to evade the tax.

One important caveat: these time periods can be paused, or “tolled,” by events such as a prior bankruptcy filing, an offer in compromise, or certain appeals. That means the dates aren’t always as simple as counting forward on a calendar, and it’s one of the reasons professional guidance matters.

Now, let’s delve into some scenarios to see how these rules apply.

Example 1: Sarah’s Second Chance

Sarah, a resident of Lewiston, Idaho, had fallen behind on her federal income taxes. Her tax debts were from the 2019 tax year, which meant the return was due in April 2020. She filed that return on time, and the IRS assessed the debt shortly after. Because the three-year rule requires waiting until the return has been due for at least three years, Sarah held off and filed for Chapter 7 bankruptcy in late 2023—more than three years after the April 2020 due date. With the two-year and 240-day rules also satisfied and no fraud involved, Sarah’s 2019 tax debts were eligible for discharge in her Chapter 7 bankruptcy, providing her with a fresh financial start.

Example 2: Mike’s Chapter 13 Strategy

Mike, a referring attorney in the Eastern District of Washington, was working with a client named John. John had substantial tax debts and wanted to avoid losing his assets. Mike suggested filing for Chapter 13 bankruptcy, which allows for a repayment plan spread over three to five years.

John’s tax debts from the 2018 tax year met all of the timing criteria by the time he filed, so they were treated as general unsecured debts rather than priority debts. That distinction matters: newer tax debts that don’t meet the rules are “priority” debts and must be paid in full through the plan, while older qualifying debts like John’s are treated like other unsecured debts. Over the life of his five-year plan, John paid what he could toward those debts, and the remaining balance was discharged at the end—all while keeping his assets intact.

Remember, It’s Not Always a Guarantee

While these examples highlight potential scenarios for discharging tax debts, it’s crucial to remember that bankruptcy is a complex legal process. The outcome can vary depending on your unique circumstances, the type of taxes owed, whether any of the time periods have been tolled, and the specific rules in your jurisdiction.

Consulting with an experienced bankruptcy attorney like Tecla Druffel, who serves clients in Idaho and the Eastern District of Washington, is essential. Tecla can evaluate your situation, guide you through the process, and help you determine the best course of action.

In conclusion, discharging taxes in bankruptcy is possible, but it’s not a one-size-fits-all solution. Real-life examples show that it can provide relief to individuals struggling with tax debts. However, every case is unique, so it’s vital to seek professional advice.

Remember, this blog post is for informational purposes only and should not be considered legal advice. If you’re facing tax-related challenges, reach out to Tecla Druffel, a bankruptcy attorney with experience helping clients just like you.