The discharge of Federal or Michigan state tax debt is a puzzling question for most consumers and even many bankruptcy attorneys. It is a mistake to assume that it can be discharged in bankruptcy, but it is also a mistake to presume that it cannot.
It is also a mistake to fail to consider other measures of relief short of discharge offered by the bankruptcy process, namely, the collections-stopping power of the initial “automatic stay” injunction and the ability to pay tax debt that is not dischargeable at zero-percent interest in a Chapter 13 bankruptcy.
TAX DEBT & THE AUTOMATIC STAY
The first benefit offered by a Chapter 7 or Chapter 13 bankruptcy with regard to tax debt is the so-called automatic stay against collections that is triggered by the filing of a bankruptcy. Regardless of whether the tax debt is dischargeable or not, the automatic stay is a Federal injunction that will stop all ongoing collection activities during the bankruptcy case—including wage garnishment, bank account garnishment, tax levies, the filing of tax liens, audits, and so on.
The filing of a bankruptcy and the automatic stay injunction will cause the IRS to transfer the bankruptcy petitioner’s file from its Collections department to its Insolvency Unit.
DISCHARGE OF TAX DEBTS IN CHAPTER 7 & CHAPTER 13 BANKRUPTCY
The question of whether a tax debt can be discharged in bankruptcy or not is not dependent upon whether it is a Chapter 7 or Chapter 13 bankruptcy being filed. The analysis is the same.
A tax debt is dischargeable under very specific circumstances. There are 5 “tests” that determine whether or not a tax debt may be discharged. In addition, there are further complicating events that must be considered by your bankruptcy attorney in conducting this analysis.
TAX DEBT BANKRUPTCY DISCHARGE TEST: THE 3-YEAR RULE
A tax debt is not dischargeable unless the tax debt was due 3 years prior to the filing of the bankruptcy.
In this context, a tax debt is “due” on the deadline for the filing of the applicable year’s return with the IRS or Michigan’s Department of Treasury. It is not the date that you filed your tax return. It is not December 31st of the tax year in question.
For example, tax debt owed for the year 2016 became due on April 15, 2017. A bankruptcy petition filed in June, 2020, would allow (potentially) the debt to be discharged as the 3-year deadline passed on April 16, 2020.
If an extension had been filed in 2017, in the above example, pushing the filing deadline back to October 15, 2017, a bankruptcy petition filed in June, 2020 would not allow the debt to be discharged. The bankruptcy petition should instead, if possible, be filed on October 16, 2020 or later.
TAX DEBT BANKRUPTCY DISCHARGE TEST: THE 2-YEAR RULE
Additionally, there is a rule holding that, if the tax return was not filed within the 2 years prior to the date of the filing of the bankruptcy case, the tax debt for the tax year in question is not dischargeable.
Thus, even if 3 years have elapsed since the date the tax debt became due at the time of the bankruptcy filing, if the tax return was filed late, within the prior 2 years, it remains non-dischargeable regardless of the 3-Year Rule.
TAX DEBT BANKRUPTCY DISCHARGE TEST: THE 240-DAY RULE
The 240-Day Rule holds that a tax debt is not dischargeable if it was assessed by the IRS or Michigan Department of Treasury within 240 days of the bankruptcy filing.
How do you know if the IRS has re-assessed your debt? You will need to retrieve something called a “tax account transcript” for each of the tax years in question for your Michigan bankruptcy attorney to review. The coding on this document will inform your attorney as to whether a recent assessment or re-assessment has occurred and enable him or her to time the filing of your bankruptcy accordingly.
This is one key reason why, if you are carrying tax debt, you retain an experienced bankruptcy attorney to represent you in your Chapter 7 or Chapter 13 filing rather than attempting to go it alone without legal representation.
TAX DEBT BANKRUPTCY DISCHARGE TEST: NO FRAUD!
The tax return also cannot have been fraudulent or filed in any other manner deemed by the IRS or Michigan Treasury to have been a willful attempt to “evade or defeat” the tax liability.
What is fraud? If that word has explicitly aimed at you by the IRS or if you have been criminal prosecuted for tax evasion, your tax debt is likely to be non-dischargeable in bankruptcy. However, there are other occasions less explicit to be found in existing case-law. Some examples include the understatement of income, extended failure to file tax returns, and failure to cooperate with the IRS.
Once again, it is crucial that an experienced bankruptcy attorney competent in tax liability discharge be retained if you should such debt obligations.
TAX DEBT DISCHARGE IN BANKRUPTCY: OTHER ISSUES
There are a variety of other issues that must be considered with regard to the possible discharge of tax debt in bankruptcy.
For example, certain events in addition to the filing of an extension will “toll” (or drag out) the waiting-time periods in 3-Year, 2-Year, and 240-Day Rules.
A prior bankruptcy, having stayed collection of the tax debt, will toll or extend the time-periods required by those Rules for dischargeability, and there are other such events that have the same effect.
Additionally, when this issue is disputed in Federal Bankruptcy Courts, the question of whether a filing is or is not a “return” as defined by both the IRS Code and the Bankruptcy Code frequently arises.
Depending upon which Court of Appeals jurisdiction you reside in, a late-filed or amended tax return is not a “return” for purposes of meeting the requirements of the Rules above. A “substitute return” filed by the IRS itself because you failed to timely do so has, until recently, generally not been held to be a “return” for this purpose (this is an evolving question).
State tax returns not timely filed after Federal returns are filed also raise questions as to the dischargeability of the tax debt.
WHEN TAX DEBT IS NOT DISCHARGEABLE: CHAPTER 13 REORGANIZATION PLAN TREATMENT
Even if your tax debt is not dischargeable, however, all is not lost.
A Chapter 13 bankruptcy is a form of bankruptcy in which some types of debt you may owe are treated in priority over other types of debt.
A non-dischargeable tax debt will be paid in a Chapter 13 payment plan in full before any garden-variety unsecured liabilities—credit card, medical, other unsecured debts—are paid anything at all.
If you have only X amount of disposable income to stave your creditors off with each month, a Chapter 13 will allow you to “dedicate” that money to your priority tax debt so that you are able to pay it off without worrying about your other creditors, and then pay in part or full and discharge the unpaid balance of the unsecured debt at the end of the Chapter 13 process.
Further, any tax debt paid will be paid at 0% interest in the Chapter 13 Plan. That is an improvement of at least a couple of percent on what the IRS charges for its non-bankruptcy payment plan arrangements every time.
TAX DEBT & MICHIGAN BANKRUPTCY: THE BOTTOM LINE
The bottom line is that, if you are considering filing for bankruptcy and are holding any income tax debt, you need to retain an experienced bankruptcy attorney to assist you.
It is highly unlikely that a lay person will perform this analysis properly, and a mistake in timing your bankruptcy filing by even a day can cost you your tax debt dischargeability.
The Law Offices of Walter A. Metzen & Associates offers free consultations for those interested in the bankruptcy process and is experienced in determining and advising as to the best treatment of income tax debt within the bankruptcy process.