Dischargeability of Taxes in Bankruptcy

(630) 960-0500

© 2016, Tony Mankus, Esq.

Businesses and individuals experiencing financial difficulties frequently have unpaid taxes due the State and Federal governments. One of the issues they need to consider in making a decision about whether to file bankruptcy is the dischargeability of these unpaid taxes. If dischargeable, the attractiveness of bankruptcy is enhanced.

The general scheme in the bankruptcy code is that all debts are dischargeable unless they are specifically excepted from discharge. In a Chapter 7 case, for example, the general issue of dischargeability is addressed under Section 727(b) which states in part:

  • Except as provided in Section 523 of this title, a discharge under subsection (a) of this section discharges the debtor from all debts that arose before the date or the order for relief under this chapter,…¹
  • In Chapter 11 cases, this issue is addressed in section 1141(d)(1) which states, in part:
    • Except as otherwise provided in this subsection, in the plan, or in the order confirming the plan, the confirmation of a plan –
    • (A) discharges the debtor from any debt that arose before the date of such confirmation,…²
  • In both Chapter 12 and Chapter 13 cases, the issue is addressed in Section 1228(a) and 1328(a) respectively, which state, in part:
    • . . . . as soon as practicable after completions by the debtor of all parts under the plan,… the court shall grant the debtor a discharge of all debts provided for by the plan…³

In the case of taxes, however, the exceptions to discharge are so numerous that they virtually swallow the rule. Nevertheless, some taxes are clearly dischargeable. The general rule is that -barring any general exceptions (to be discussed later) – taxes meriting eighth priority under Section 507(a)(8) of the Code are  not dischargeable; taxes not meriting the priority  are dischargeable.

INCOME AND GROSS RECEIPT TAXES

The dischargeability of unpaid income and gross receipt taxes is dealt with by an interplay between Sections 523(a)(1) and 507(a)(8) of the Code, though it takes some reverse interpretation and cross referencing to reach that conclusion.

  • Section 523 deals with exceptions to discharge. Section 523(a) states in part:
    • A discharge under 727, 1141, 1228(a), 1228(b) or 1328(b) of this title does not discharge an individual debtor from any debt –
    • (1) for a tax or custom duty –
    • (A) of the kind and for periods specified in Section 507(a)(3) or 507(a)(8) of this title,…⁴
  • Section 507 deals with priorities. Section 507(a)(8) states, in part:
    • The following expenses and claims have priority in the following order:
    • (8) Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for –
    • (A) a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition –
      • for which a return, if required, is last due, including extension, after three years before the filing of the petition; ⁵

Combining the two sections, one comes to the conclusion that income and gross receipt taxes are dischargeable in bankruptcy under Section 523(a)(1)(A) of the Code if they meet two conditions:

  • (1) the tax returns to report such unpaid income or gross receipts were due more than three (3) years before the petition date and,
  • (2) they were filed timely.

Thus, for example, 2011 and 2012 Federal income taxes, filed on or before their due dates, are both dischargeable if the taxpayer's petition for bankruptcy is filed April 16, 2016, or later. If the petition for bankruptcy is filed April 14, 2016 or earlier, the 2012 taxes are not dischargeable since the petition was filed less than three years after the presumptive due date of the return. This is true even if the 2012 tax return had  actually been filed prior to April 14, 2013. The three year measurement period begins with the last date the return is legally due to be filed, not from the date the return is actually filed.⁶

If the petition is filed on April 15, 2016, it is arguable that the 2012 income taxes are not dischargeable since they are due  more than three years from the petition date. There is no known case law on the precise issue; however, bankruptcy rule 9006 seems to support this contention.⁷ Under the circumstances, the debtor contemplating the filing of bankruptcy on April 15th would be well advised to wait an extra day, if at all possible.

Several other points should be remembered with regard to the three year computation period. First, if there is any valid extension date, the three years begin to run from the extension date.⁸ Thus, if the Internal Revenue Service had given the debtor a one hundred twenty day extension to file his 2012 tax return, any unpaid taxes would not have been dischargeable under a petition filed before August 15, 2016.

Second, the legal due dates of the returns are extended by the Internal Revenue Service if they fall on the weekend or legal holidays.⁹

In 2017, for example, April 15 is a Saturday; the 2016 personal income tax return is not due until April 17, 2017. Consequently, any filing to discharge the 2016 taxes should not be made before April 18, 2020.¹⁰

LATE RETURNS

If the income and gross receipt tax returns are filed late, the taxes can likewise be discharged, but under Section 523(a)(1)(B)(ii) rather than 523(a)(1)(A) – provided that the late returns are filed more than two years before the petition date.¹¹

The important distinction to remember between the timely return and the late return is that the timely filed return the three year discharge date is computed from the presumptive filing date, while in the late return the two year discharge date is calculated from the actual filing date.

Thus, if the taxpayer's 2011 and 2012 income tax returns are both filed on May 1, 2014, while his petition for bankruptcy is made on April 16, 2016, any taxes still due for those periods on the date of petition are not dischargeable. On the other hand, if those returns are filed April 15, 2014 or prior, any taxes due are dischargeable.

It is interesting to note the discharge interplay between a timely filed income tax return and a late one. The code seems to favor the delinquent filer in that he need only wait two years after filing to get a discharge, while the timely filer must wait at least three.

This is partly illusory in that the start of the computation period is different. It is somewhat like comparing apples and oranges. Nevertheless, the code does seem to clearly favor the delinquent filer in the specific case of a tax return due more than two years, but less than three before the petition date. If it is filed timely, it is non-dischargeable; if it is filed late – but within a year after it is due – it is dischargeable.

For example, let's take the petition date of September 30, 2016 and unpaid income taxes due for 2013. If the tax return is filed on April 15, 2014, the due date, the taxes are non-dischargeable. The return was filed timely and does not meet the three year test of Section 523(a)(1)(A). On the other hand, if the tax return is filed July 30, 2014, the test would be under Section 523(a)(1)(B)(ii) and the tax  would be dischargeable.

The individual who has the prescience to foresee his bankruptcy two years hence can take advantage of this seeming loophole by filing his return late. Likewise, the habitually delinquent filer may be rewarded by an extra year's discharge – provided that the Internal Revenue Service does not collect the money before then.

Another interesting possibility is that  any unpaid tax or custom duty – not only income on gross receipt tax – is dischargeable if it is filed late and more then two years prior to the petition date. A literal reading of this section could render such an interpretation feasible. There is no known evidence of a debtor having attempted it, however.

240 DAY RULE

Also dischargeable are unpaid income and gross receipt taxes which were assessed¹² more than 240 days prior to the filing of the bankruptcy petition. This is derived from an interplay between section 523(a)(1)(A) (previously cited) and Section 507(a)(8)(A)(ii). The relevant portions of Section 507(a)(8)(A)(ii) state as follows:

  • (8) Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for –
  • (A) a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition –
    • (i) (i)for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;
    • (ii) assessed within 240 days before the date of the filing of the petition…¹³

This section of the code is somewhat confusing. It is not clear as to how it ties in with the other sections discussed above. Is it an either/or situation allowing for a discharge either under the three year filing rule (or two year rule if the return is filed late)  or the 240 day assessment rule; or is it an  and situation requiring that the unpaid taxes meet both the 3 year (or 2 year) filing test  and the 240 day assessment tests?

There is some case law to suggest that this is an either/or test. In the case of In Re Coleman American Moving Services, Inc., the court held that to be entitled to priority treatment the tax must either have been due three years prior to the debtor's petition date pursuant to Section 507(a)(8)(A)(i) or amended within 240 days of the petition date pursuant to Section 507(a)(8) (A)(ii), but it need not satisfy both conditions.¹⁴

It should be noted, however, that the court ruled on the companion issue of  priorities, and not specifically on discharge. Even though these two issues are bound together by the structure of the Code, treating them identically in all situations could have illogical results. Thus, if the either/or language of the court were applied to discharge, it could, for example, result in a deficiency audit assessment being discharged even prior to the expiration of the 240 days in the case of it being made on a timely filed tax return just prior to three years after the presumptive filing date. In an either/or situation the taxpayer/debtor could petition for bankruptcy shortly after the three year period and get a discharge on the additional tax assessment. This would seem to be clearly contrary to the intent of the Code.

A better interpretation for discharge purposes, it seems, would be to require that the tax question meet  both tests independently. That is, to be dischargeable, the tax return must be both filed three years before the petition (or two years if filed late),  and the tax must be assessed for at least 240 days.

Under this interpretation of the Code, the result would be more logical and balanced. Take the case, for example of a 1991 Federal income tax return filed April 10, 1992 and assessed on June 15, 1992. It is then audited by the Internal Revenue Service in 1994 and additional tax is assessed on November 15, 1994. If the bankruptcy petition is filed on May 15, 1995, the unpaid balance of any tax initially assessed on June 15, 1992 is discharged since the return was filed timely and the presumptive filing date was more than 3 years prior to the petition date. The additional tax assessed on November 15, 1994 is  not discharged since it was assessed less than 240 days prior to the petition date.

If the petition is filed on July 30, 1995, however, both the initial tax and the additional tax are discharged since they both meet their separate tests independently.

This interpretation seems consistent with a more recent Illinois bankruptcy case where the court considered both the issue of priorities  and the issue of dischargeability. In Easton v. United State of America, the court held that for purposes of priority the either/or test applied, but that this, in effect, requires an  and test for purposes of discharge. If taxes meet the priority test under  either Section, they have to be non-dischargeable. Conversely, to be dischargeable, the taxes must meet  both tests. The mirror image of the either/or test in priority issues is an  and test in discharge issues.¹⁵

Subsequent case law has confirmed this interpretation. In In re Torres, 117 B.R. 379 (B. Ct. N.D. Ill. 1990) the court held that the three year rule of 11 USC §507(a)(8)(A)(i) and the 240 day rule of 11 USC §507(a)(8)(A)(ii) are not mutually exclusive or alternative avenues to dischargeability. Both of these statutory tests must be satisfied before the income tax liability will become dischargeable.

OFFER IN COMPROMISE

This 240 day period of non-dischargeability can be extended by the filing of an Offer in Compromise after the additional assessment. If before the 240 day period runs out, the taxpayer files an Offer in Compromise, he should not file a petition for bankruptcy – if he can possibly avoid it – since the 240 day period is extended for the time that the Offer is being considered administratively by the Internal Revenue Service, plus an additional 30 days.¹⁶

WITHHOLDING TAXESWithholding taxes, such as the income and social security taxes withheld by employers from their employees, are generally not dischargeable.¹⁷

The employer's portion of the withholding taxes relating to wages earned from debtor before the bankruptcy petition (whether or not actually paid by employer/debtor) will be discharged if the return was due and filed timely (including extensions) more than three years before the petition date.¹⁸ For example, the employer's portion of the social security taxes payable on a Federal 941 tax return for the period ended September 30, 2011 is dischargeable if the petition for bankruptcy is filed by the employer/debtor after October 31, 2014 (three years after the due date of the return). Section 523(a)(1)(B)(ii) allows for discharge of such taxes even if the return is filed late – provided, however, that is was filed more than two years before the petition date.¹⁹

EXCISE TAXESAlso dischargeable are excise taxes such as estate and gift taxes, gasoline and special fuel taxes, wagering and truck taxes and state sales taxes, provided that the petition for bankruptcy was filed more than 3 years after the due date of the return.²⁰ If the return is filed late, the 2 year rule applies.²¹ If no return is required, the transaction which gave rise to the excise tax must have occurred more than three years before the petition date.²²

CUSTOM DUTIES

Custom duties arising out of the importation of merchandise may also be discharged in bankruptcy provided they meet the one year or the four year tests.²³

EXCEPTIONS TO DISCHARGE

As stated at the beginning of the article, the exceptions to discharge are so numerous that they virtually swallow the rule. A detailed discussion of the exceptions will not be attempted here. The general exceptions to discharge, applicable to all chapters of the bankruptcy Code, are listed in Section 523. They include, among others, taxes due that were not reported on a tax return,²⁴ taxes fraudulently reported on the return,²⁵ and taxes not listed or scheduled on the bankruptcy petition.²⁶

The specific exceptions to discharge are listed in each chapter. In a Chapter 7 case, the exceptions are listed under Section 727.²⁷ For example, the Court will not grant a discharge to a debtor who is not an individual.²⁸ Thus a corporation or partnership owing taxes should not petition a bankruptcy court for relief under Chapter 7 since it cannot get a discharge. Likewise, the court will not grant a discharge to a Chapter 7 debtor who has transferred property within one year of the petition date with intent to defraud a creditor,²⁹ or the debtor had been granted a previous discharge within 6 years of the petition date.³⁰

The Chapter 11 exceptions are listed under Section 1141(a).³¹ The Chapter 12 and Chapter 13 exceptions to discharge are listed under Section 1228³² and Section 1328 respectively.³³

TIME OF DISCHARGE

In a Chapter 7 case, the discharge occurs sixty days after the first meeting of creditors – unless someone objects.³⁴ In a Chapter 11 case, the discharge occurs upon confirmation of the plan.³⁵ In Chapter 12 and 13 cases the discharge occurs upon completion of the plan, except that both chapters provide for a hardship discharge before completion of the plan.³⁶

GENERAL OBSERVATIONS

A distinction should be made between the terms “discharge” and “dischargeable”. Just because a tax is dischargeable, it does not mean that it will be discharged. For example, if there are sufficient non-exempt assets in the Chapter 7 estate of the debtor to pay some or all of the taxes, they must be paid by the trustee even though they are dischargeable.³⁷ This is an unlikely scenario because a debtor with significant assets to pay off taxes should not elect Chapter 7 bankruptcy, but it is theoretically possible.

Likewise, if a Chapter 12 or 13 plan calls for full payment of dischargeable taxes, they must be paid, or there will be no discharge.³⁸ The trick here is to propose and/or negotiate a plan that will avoid such a situation.

In addition, dischargeable taxes secured by a federal tax lien on pre-petition property of the debtor must be paid by the trustee from the proceeds of the property to the extent of the security interest.³⁹

POST-DISCHARGE CONSIDERATIONS

But even if the debtor is successful in jumping over all the legal discharge hurdles, several post discharge hurdles still remain. First, discharged taxes can be collected from exempt property of the debtor if the State and Federal government has a recorded pre-petition lien.⁴⁰ The good news it that, as a matter of practice, the Internal Revenue Service in the Chicago District generally does not proceed against exempt property – possibly because the exemptions are relatively small.⁴¹ The largest exemption in Illinois is the $15,000.00 homestead exemption.⁴² If a husband and wife file a joint petition for bankruptcy, the maximum allowable is $30,000.00. The other exemptions are much smaller.

The bad news is that, not infrequently, the Internal Revenue Service fails to release the lien or to abate the discharged tax. Sometimes it even attempts to collect from non-exempt property or offset post petition refunds against the discharged tax. All of these things are arguably in violation of the permanent injunction established under Section 524,⁴³ though that is a topic for another article.

CONCLUSION

​If the taxes are dischargeable, bankruptcy is a more attractive alternative than if they are not, but one should be aware of the various hurdles to be encountered both before and after discharge.

  1. 11 USC §727(b)
  2. 11 USC §1141(d)(1)
  3. 11 USC §1228(a); 11 USC §1328(a)
  4. 11 USC §523(a)
  5. 11 USC §507(a)(8)
  6. Hammerer v. Internal Revenue Service, 6 CBC 2nd 358 (E.D. Wisconsin, March 16, 1982)
  7. Rule 9006 reads in part:
    1. (a)       Computation.  In computing any period of time prescribed or allowed by these rules, by the local rules, by order of court, or by any applicable statute, the day of the act, event, or default from which the designated period of time begins to run shall not be included.  The last day of the period so computed shall be included, unless it is a Saturday, a Sunday, or legal holiday, in which event the period runs until the end of the next day which is not a Saturday, a Sunday, or a legal holiday.
  8. 11 USC 507(a)(8)(A)(i)
  9. 26 USC §7503
  10. Hammerer v. Internal Revenue Service, 6 CBC 2nd 358 (E.D. Wisconsin, March 16, 1982)
  11.  The relevant portions of 11 USC §523(a)(1)(A)(ii) state as follows:
    1. (a)       A discharge under section 727, 1141, 1228(a) 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt -
    2. (1)       for a tax or a customs duty
    3. (B)      with respect to which a return, if required -(ii) was filed after the date on which such return was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition;
  12. It should be noted that the reference here is to the date of assessment of the tax rather than to the date (or presumptive date) of the filing of the return, as in the two previous examples discussed above.
  13.  11 USC §507(a)(8)(A)(ii)
  14. In Re Coleman American Moving Service, Inc., 6 CBC 2nd 1065 (District of Kansas, October 23, 1981)
  15. In Re Easton, 59 B.R. 714 (Bankruptcy C.D. Ill. 1986)
  16. The relevant portions of Sec. 507(a)(8)(A)(ii) state as follows:
    1. (8) Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for -
    2. (A)       a tax on or measured by income or gross receipts - (ii) assessed with 240 days, plus any time plus 30 days during which an offer in compromise with respect to such tax that was made within 240 days after such assessment was pending, before the day of the filing of the petition.
  17. The relevant sections of the Code are Sec. 523(a)(1)(A) and Sec. 507(a)(8)(C) which states, in part:
    1. (8) Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for -
    2. (C) a tax required to be collected or withheld and for which the debtor is liable in whatever capacity:
  18. The relevant sections of the Code are Sec. 523(a)(1)(A)(cited above) and Sec. 507(a)(8)(D) which states, in part:
    1. (8) Eighth, allowed unsecured claims of government units only to the extent that such claims are for -
    2. (D)an employment tax on a wage salary, or commission of any kind specified in paragraph (3) of this subsection earned from the debtor before the date of the filing of the petition, whether or not actually paid before such date, for which a return is last due, under applicable law or under any extension; after three years before the date of the filing of the petition;
  19. 11 USC §523(a)(1)(B)(ii)
  20. 11 USC §523(a)(1)(A); Section 507(a)(8)(E)
  21. 11 USC §523(a)(1)(B)(ii)
  22. 11 USC §523(a)(1)(A); Section 507(a)(8)(E)(ii)
  23. 11 USC §523(a)(1)(A); Section 507(a)(8)(F)
  24. 11 USC §523(a)(1)(B)(i)
  25. 11 USC §523(a)(1)(C)
  26. 11 USC §523(a)(3)
  27. 11 USC §727
  28. 11 USC §727(a)(1)
  29. 11 USC §727(a)(2)
  30. 11 USC §727(a)(8)and(9)
  31. 11 USC §727(d)
  32. 11 USC §1228
  33. 11 USC §1328
  34. Bankruptcy Rule 4004
  35. 11 USC §1141
  36. 11 USC §1228 and Section 1328
  37. 11 USC §727
  38. 11 USC §§1228 and 1328
  39. 11 USC §§724 and 725
  40. 11 USC §522(c)(2)(B)
  41. 735 ILCS 5/12-1001
  42. 735 ILCS 5/12-901
  43. 11 USC §524

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