Are Unpaid Taxes Dischargeable?
Delinquent IRS income tax debt is a growing problem. In 2014, Americans owed over $130 billion in unpaid income taxes, which is about $10 billion more than they owed in 2013. Many other people owe back taxes to the DFA or a similar agency in another state. In many cases, bankruptcy wipes out tax debt, even if the account has been open for years or decades.
Many bankruptcy debtors have an entirely different kind of tax issue, because they either expect to receive, or have recently received, a large refund. In years gone by, a tax refund often meant a nice spring break trip or a slightly higher standard of living, at least for a few weeks. But increasingly, people depend on their spring refunds to make car repairs they’ve put off or pay other necessary expenses. Do debtors in bankruptcy get to keep some, most, all, or none of their tax refunds?
Discharging Taxes in Bankruptcy
Many people are self-employed either full or part time, and they fell behind on tax payments due to unanticipated financial conditions. In these cases, the taxing authority typically agrees to a payment plan but seldom agrees to reduce the amount due. In other situations, the taxpayer and taxing authority have a legitimate dispute as to the amount due, and as long as the disputed returns meet the qualifications set out below, the entire unpaid amount is dischargeable.
Roughly the same rules apply in both types of consumer bankruptcy (Chapter 7 liquidation and Chapter 13 repayment); some different rules may apply in Chapter 11 reorganizations and Chapter 15 family farm bankruptcies, but consumers hardly ever file under Chapters 11 or 15.
Some public debt – like past-due child support and student loans – is difficult to impossible to discharge under almost any circumstances. But income tax debt is different. These debts are dischargeable if the following conditions are present:
- Income Tax: Only personal income taxes are dischargeable in a consumer bankruptcy. Corporate income taxes may or may not be dischargeable in a Chapter 11 or a business Chapter 7. Other types of taxes, like property, estate, or payroll taxes, are not dischargeable.
- Promptness: The returns must have been filed on time, and the “substitute” returns that the IRS or other taxing authority files on your behalf do not count. A few exceptions may apply in some cases, but don’t count on it.
- Time: The taxes must be at least three years old. So, tax year 2011 taxes that were due on April 15, 2012 were dischargeable as of April 15, 2015. If the taxpayer obtained multiple extensions, special rules may apply.
- Mental State: If the taxpayer willfully failed to pay, or committed another form of fraud like using a false Social Security number, the taxes are generally not dischargeable. An attorney can discuss the concept of “willful failure to pay” with you, but it is a safe bet that the taxing authority will dispute the discharge on this ground, especially if the amount is significant.
- 240 Days: If the debt has not been assessed in the last 240 days, which essentially means that the taxing authority has not sent a collections letter in the previous nine months, qualified debts are dischargeable.
Unpaid tax debts nearly always involve adverse action. Bankruptcy stops some of these actions, like lawsuits, but does not stop others, like liens that have already been filed.
Keeping Income Tax Refunds in Bankruptcy
In 2015, roughly 100 million taxpayers received an average $2,700 refund. That figure is particularly important when examining the pragmatic aspects of keeping a tax refund.
In both Schedule I and on the Statement of Financial Affairs, taxpayers must disclose any anticipated increases or decreases in income, including year-end work bonuses and income tax refunds. Moreover, debtors have a duty to amend their schedules prior to discharge, if their financial circumstances significantly change. Furthermore, in most jurisdictions, trustees require debtors in bankruptcy to turn over copies of their tax returns. The bottom line is that, unless the debtor files Chapter 7 in the early summer and it is discharged within the next six months, the trustee will find out about the refund. And, since all the debtor’s property technically belongs to the bankruptcy estate, the tax refund legally belongs to the trustee, who can distribute it to the creditors.
A brief word before we go further. Most bankruptcy trustees care little about the creditors. However, they care a lot about the incentive they receive for locating non-exempt property – like cash – and distributing it among the creditors. The amount varies by jurisdiction, but most districts let trustees keep 10 percent of the money they obtain in motions for turnover.
So the trustee gets to keep $270 from the average refund. In order to obtain that $270, the trustee must draft a motion for turnover, file it, attend at least one hearing, and negotiate with the debtor’s attorney. Roughly 95 percent of these matters settle out-of-court, often for about fifty cents on the dollar. So, in our hypothetical situation, the trustee has jumped through an inordinate number of hoops to obtain $135. Many times, it’s simply not worthwhile, so most trustees have a pre-determined cutoff; for example, if the refund is under $2,000 they do nothing, but if it’s over $2,000 they will file a motion for turnover.
Bankruptcy is all about getting a fresh start, even if you have certain kinds of tax debt. For a free case evaluation, contact Niblock & Associates. Mr. Niblock is a member of the National Association of Consumer Bankruptcy Attorneys.