Treatment Of Taxes in Bankruptcy

Treatment Of Taxes in Bankruptcy

A common belief is that taxes are not affected by a bankruptcy. That is not so. What should be remembered is that the Internal Revenue Service is a creditor just like any other, subject to the same limitations and restrictions as any credit card company or health care provider.

Once a bankruptcy is filed the IRS must cease its collection activity, just like all other creditors must do.

What primarily separates the IRS from other creditors is not so much its position in the government but the nature of the debt owed to it–TAXES, the treatment of which is governed by the Bankruptcy Code.

Two common taxes subject to being discharged in bankruptcy, or if not discharged are treated differently in a bankruptcy than other types of debts, are payroll taxes and personal income taxes.

Personal Income Taxes

There are three time lines which must be met to qualify a personal income tax obligation to be discharged. If, prior to the filing of the bankruptcy, 1) the tax was due more than 3 years before; 2) the taxpayer filed a tax return; and 3) the tax was assessed more than 240 days prior.

Let’s look at those timelines.

• Three-Year Rule: Income taxes are due in April of the year following the tax year. A tax owed for 2021 tax year would not be due until April 2022. The earliest the taxpayer could file bankruptcy so as to discharge the tax obligation would be April  2025. If the tax year was 2023, a bankruptcy filing prior to April 2026 would not be good, but any time after April 30, 2026 would be good to satisfy this requirement.
• Two-Year Rule: The tax return for the year for which money is owed must be filed by the taxpayer at least 2 years before the bankruptcy filing, and on time. The taxpayer must be the one to file the return. There are situations in which IRS will file a return for the taxpayer. That is not being helpful, that is to establish a $ amount so that the tax may be assessed and the IRS collection system can do their things. Those IRS-filed returns will not suffice.
• 240-Day Rule: This date means that the IRS has determined what the tax actually is.  The taxpayer filing a return does not mean it was accurately prepared, or that the government accepts the treatment of income, deductions, etc.  Once the assessment is made, there is now a definitive $ amount as to what the government claims is owed.  Tax liens filed by the IRS will reflect the date of the assessment.  If a tax lien has not been filed, then there are other indicia as to the assessment date, such as collection letters.

Payroll Taxes

Payroll taxes fall into two primary categories–funds withheld from the employee’s wages–7.65% for Social Security and Medicare and X% for income tax–and the employer’s matching tax of 7.65% for Social Security and Medicare.

Funds withheld from employees not turned over to the IRS create an obligation not only on the business, but also officers, directors and managers of corporations and LLC’s or partners of partnerships.  THOSE funds of the employee are considered to be held in Trust for the benefit of the employee.  Money not turned over is a non-dischargeable debt of the employer.  If the employer is a partnership, corporation or LLC, the partner, officers, directors, and managers of the business entity are personally liable for payment of the money and they can not discharge the debt either.

However, the business owner’s matching obligation of the 7.65% for Social Security and Medicare is a tax on the business.  The funds are not held in Trust.  THOSE obligations to the IRS can be discharged in bankruptcy.

Please feel free to contact Mr. Lampert for a free consultation.