Tax Debt and Bankruptcy

Contrary to common belief, income tax debt is dischargeable in Chapter 7 bankruptcy if it meets specific timing and procedural tests. Many of our Miami clients arrive thinking the IRS debt has to be paid in full. Often the older portions can be wiped out in a Chapter 7 case, and the remainder paid through Chapter 13 without further interest or penalties accruing.

The rules below apply to federal income tax. State income tax follows similar rules in most states (Florida has no state income tax, so this is mainly relevant for clients with debt from other states). Different rules apply to payroll trust-fund taxes, sales taxes, and certain other tax categories.

The Three Timing Tests for Income Tax Discharge

Federal income tax debt can be discharged in Chapter 7 only if all three of the following are true on the date of filing:

1. The Three-Year Rule

The tax return for the year in question was due (including extensions) more than three years before the bankruptcy filing. For tax year 2020, the return was due April 15, 2021 (or October 15, 2021 with extension). The earliest a 2020 tax debt becomes dischargeable is April 15, 2024 (or October 15, 2024 if the taxpayer extended).

2. The Two-Year Rule

The tax return was actually filed more than two years before the bankruptcy. A late-filed return restarts this clock from the date of late filing. Some courts (the strict "one-day-late" rule) hold that a return filed even one day late never qualifies as a "return" for discharge purposes – the Eleventh Circuit has expressed sympathy for this position in dicta. We address late-filing risk carefully.

3. The 240-Day Rule

The tax was assessed more than 240 days before the bankruptcy filing. Most income taxes are assessed shortly after the return is filed, but audit adjustments and amended returns reset the assessment date.

Additional Requirements

• The return must not have been fraudulent
• The taxpayer must not have willfully attempted to evade or defeat the tax

Tax Liens Survive the Discharge

Even when the underlying tax debt is discharged, a previously-recorded federal tax lien (Notice of Federal Tax Lien) remains attached to property the taxpayer owned at the time of recording. The discharge eliminates personal liability for the tax; it does not strip the lien on the property. The lien continues to encumber the property for sale and refinance purposes until paid, expired (10-year IRS lien life, subject to renewal), or released.

This dynamic matters most for taxpayers with substantial equity in real estate. Strategic timing – ideally before a tax lien is recorded – can preserve the option to discharge the tax debt without the lien complication.

Trust-Fund Taxes: Generally Not Dischargeable

"Trust-fund" taxes – the employee's share of payroll taxes the employer is required to withhold and remit – are non-dischargeable as to the responsible individuals personally. Section 6672 of the Internal Revenue Code makes the responsible person personally liable for unpaid trust-fund amounts. Small-business owners with unpaid payroll-tax liability cannot discharge this exposure in personal bankruptcy.

Sales Tax

Florida sales tax operates under a similar trust-fund framework. Unremitted sales tax is generally non-dischargeable for responsible individuals personally.

Chapter 13 and Tax Debt

Even tax debt that does not qualify for discharge in Chapter 7 can be managed effectively in Chapter 13:

• Recent income tax that does not yet meet the three-year rule is a "priority claim" and must be paid in full through the plan
• Interest and penalties on priority tax claims generally stop accruing during the plan
• Non-priority older tax debt that does qualify for discharge can be treated as general unsecured and paid only the percentage other unsecured creditors receive
• Tax liens can be paid as secured claims to the extent of equity in the liened property, with the unsecured remainder discharged

The IRS Offer in Compromise Alternative

For some taxpayers, an IRS Offer in Compromise produces a better outcome than bankruptcy – particularly for taxpayers with low income and few assets whose collection statute is approaching expiration. We compare the OIC analysis with the bankruptcy analysis for clients with substantial tax debt.

Common Mistakes

• Filing bankruptcy too soon after the three-year, two-year, or 240-day periods (an extra month often makes the difference)
• Failing to file old tax returns before the bankruptcy (un-filed returns block discharge of the underlying tax)
• Not getting an IRS account transcript to verify the assessment dates and filing history
• Filing after a recorded NFTL when timing could have avoided the lien

Schedule a Consultation

Tax debt cases reward careful preparation. Call 786-522-1411 or email [email protected]. We will pull IRS account transcripts, run the timing analysis, and tell you exactly what relief is realistic.