Federal, State and Sales Taxes Can be Discharged in Bankruptcy.
One of the most commons questions I am asked during a consultation is whether unpaid state or federal
taxes are discharged in bankruptcy. My lawyerly answer to that question is…well it depends. The bankruptcy
code states that state and federal taxes are generally non-dischargeable unless certain elements are
satisfied.
Three Year Test.
First, the tax year in question has to be more than three years before the filing of the bankruptcy petition.
This means that more than three years must have passed from the date the tax return was first due. This is
usually April 15th of the following year, plus any extension to file the return.
Two Years Test.
Second, the tax return for the year in question must have actually been filed by the taxpayer more than 2
years prior to the date of the bankruptcy petition. This is a very important element. It seems simple enough,
but many times I go over the elements with a potential clients with old unpaid taxes only to find out that the
client never filed the tax return for the year in question or worst yet, the IRS filed a “substitute return”. A
substitute return does not satisfy this element and the unpaid old taxes will not be discharged if the IRS filed
the return for you…NO EXCEPTIONS!
240 Day Test.
The tax in question must have been assessed more than 240 days prior to the bankruptcy filing. If there was
an offer to compromise in effect, there are different rules which are beyond the scope of this article. Also, for
California state taxes, since by state law tax assessments are not final until 60 days after the assessment,
the 240 day rule is extended by 60 days.
Fraud.
There must be no fraud or allegation of fraud. A discharge is not allowed for a tax “with respect to which the
debtor made a fraudulent return or willfully attempted in any manner evade or to defeat such tax.”
No Tax Lien.
If the IRS or state taxing authority has a valid lien on a property for unpaid taxes prior to the filing of the
bankruptcy, the IRS or the state taxing authority can still collect on the unpaid taxes even if the court grants a
discharge.
Penalties and Interest.
Penalties and interest for unpaid taxes are also dischargeable if the above elements are satisfied.
Employment Taxes.
Employment taxes are never dischargeable in bankruptcy because the employer is obligated to withhold
these taxes and hold them in trust for the benefit of the employee’s social security and unemployment
insurance.
Sales Tax.
The issue of discharging sales taxes are a complicated one and mainly depend of whether your state treats
these taxes as a “trust fund tax” or “excise tax”. California treats sales tax as an excise tax and therefore
sales taxes are dischargeable if more than three years has elapsed from the filing of the return, or if no return
is required, three years from the date of the sales transaction that gave rise to the tax.
Property Tax.
Finally, property taxes are dischargeable if they were assessed and payable within one year before the
bankruptcy petition was filed. As you can see, the dischargeability of taxes is a complicated issue. If the
bankruptcy petition is filed prematurely, the tax obligation will not be discharged, even if the premature
petition is dismissed and refiled. This makes it very important to consult with a competent bankruptcy
attorney.