It may not be common knowledge but income taxes can be discharged in bankruptcy if certain rules are met.

To begin with, in order to be dischargeable taxes must meet the three-year rule. That is, they may not be discharged prior to three years after the due date of a return including extensions.

In order to be discharged in bankruptcy, taxes must also meet the 240-day rule. To illustrate, If the taxes sought to be discharged stem from an audited or amended return, 240 days must pass after the date of assessment prior to discharging the tax.

The third rule relating to discharging income taxes in bankruptcy which is the focus of this article is the 2-year rule. This rule in particular applies to late filed tax returns. If a tax return is filed more than 12 months after its due date, two years after the date the return was filed must pass before the tax may be discharged.  The IRS claims that in certain cases, if they assess liability prior to the taxpayer filing a return, it should not be dischargeable in bankruptcy.

In the case of Smith v. IRS, No. 14-15857 (9th Cir. 2016), the IRS’s position was tested…and the IRS won. Below is a summary of how the court came to its decision…

In 2002 a US taxpayer (Smith) failed to file his 2001 tax return by the prescribed due date. In fact, it was not until 7 years following that the taxpayer filed a delinquent return. At the time the return was filed, approximately 3 years had already passed since the IRS assessed liability against the taxpayer for the 2001 tax year in the form of a Substitute for Return (“SFR”).  Subsequent to filing the late return and allowing the two-year period to pass, the taxpayer petitioned for the 2001 taxes to be discharged. The bankruptcTaxes and Bankruptcyy court initially granted the taxpayers request.

Unfortunately for the taxpayer however, the IRS contested the ruling by appealing the case to the US District Court. The US District Court found in favor of the IRS. Subsequently, the taxpayer appealed the case to the US Court of Appeals. In their decision, the US Court of Appeals sided with the US District Court and determined that the late filed return was not dischargeable under 11 U.S.C. 523(a)(1)(B)(i). They claimed that a return filed 7 years after its due date and 3 years after an IRS assessment was not an “honest and reasonable” attempt to comply with the tax code.

The take-away here is that even if your clients cannot afford to pay their taxes when they are due, they should still file a tax return and the return should be filed timely. No one enjoys facing the possibility of needing to file for bankruptcy, but should it become necessary, it is nice to know that one’s taxes will be wiped away with all of their other dischargeable debt.

The US Court of Appeals made their decision based upon what they determined was and was not an “honest and reasonable” attempt to comply with the tax code. There is some subjectivity in the court’s decision.

By filing one’s returns timely, the ability to discharge the tax becomes more black and white. If you have client’s that cannot afford to pay their tax liability, be sure to let them know that not filing their returns limits their options in dealing with their tax issues in the future.