A tax can either be dischargeable or nondischargeable.
If a tax is dischargeable, it means that in a Chapter 7 it goes away completely. In a reorganization case, like a Chapter 13 or Chapter 11, it can often be paid pennies on the dollar and then be wiped out completely after the plan is completed.
However, if a tax is nondischargeable, your only bankruptcy option is to force a long-term payment plan (up to five years) on the government in a Chapter 13 or Chapter 11 plan. Many people choose to do this because it can be the best among bad options when a tax is nondischargeable. However, in this scenario, you must pay the taxes is full over the life of the plan. A Chapter 7 will not affect a nondischargeable tax unless you have an “asset case” and your assets are sold by the trustee to pay part or all of the tax.
So whether or not a tax is dischargeable can matter a lot. I’ll address specific types of taxes below.
Income taxes are the most common type of tax we deal with. There are five key rules regarding the dischargeability of state or federal income tax in bankruptcy. All five tests must be met for the income tax to be dischargeable.
1. The tax return for the tax in question was due at least three years before the filing of the bankruptcy case. This includes any allowed extensions.
Example: The return for 2009 taxes was due on April 15, 2010. Consequently, this dischargeability test would be met for bankruptcy cases filed after April 15, 2013. However, if you sought an extension and pushed the original due date out to October 15, 2010, the dischargeability test would only be met after October 15, 2013.
2. The tax return was filed at least two years before the bankruptcy case. The corollary to this is that all income taxes are nondischargeable for all years with un-filed returns.
3. The tax must be assessed 240 days prior to the bankruptcy case. When you file a normal return with a balance and simply don’t pay, the tax will be assessed shortly thereafter based on your reported balance due. Assuming no audit or adjustment, that assessment will stand. As long as 240 days pass between the assessment and the bankruptcy filing, this dischargeability test is met.
4. The tax return is not fraudulent or frivolous. In other words, as long as you honestly report your income and follow the rules regarding deductions with good faith and a reasonable degree of diligence, you should pass this dischargeability test.
5. You must not be guilty of tax evasion.
If all five of these tests are met, an income tax is dischargeable in bankruptcy. Depending on the type of bankruptcy you file (and qualify for), the tax can either be discharged completely in Chapter 7 or paid partly in a Chapter 13 or Chapter 11.
Sales and Use Tax
These types of taxes are called “trust fund” taxes, and are certain funds that the law requires you to collect from others and pay to the taxing authority. Common trust fund taxes are are sales, use, and certain payroll taxes. Section 507(a)(8)(C) of the Bankruptcy Code refers to these as “a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.” These taxes are never dischargeable in bankruptcy, but they can be paid back in full over the life of a Chapter 13 or Chapter 11 plan.
The personal liability associated with a property tax is dischargeable as long as the property tax was incurred before the case and was last payable without penalty a year before that date. However, Massachusetts law gives an automatic lien to city and towns for unpaid property taxes. The super-priority status of this lien means that dischargeability seldom becomes an issue because the municipality can collect the tax from the sale of the property if it doesn’t get paid from the homeowner. In other words, discharging real estate property tax is not possible if you want to keep the property. However, whether or not a property tax is dischargeable (and thus non-priority) can matter for plan treatment in a reorganization case.
The Massachusetts Bankruptcy Court has held that the annual automobile tax is an excise and not a property tax. If you’re interested, you can read that opinion here: In re Appugliese, 210 B.R. 890 (Bkrtcy.D.Mass 1997). The court found that even though the tax is calculated based on the value of the car, it is a tax on the privilege of driving a car and, thus, an excise tax.
In general, excises taxes are dischargeable if they are more than three-years old when the bankruptcy case is filed.
Interest and Penalties on Taxes in Bankruptcy
Interest, penalties, and even interest on penalties is nondischargeable if it arises from a nondischargeable tax. The status of the interest and penalties follow from the status of the underlying tax. Once a tax is dischargeable, the interest and penalties flowing from it are dischargeable too.
Post-petition interest on a nondischargeable tax debt accruing during a bankruptcy case is also nondischargeable and remains the personal liability of the debtor when the case is concluded. See Bruning v. United States, 376 U.S. 358, 360, 84 S.Ct. 906, 907, 11 L.Ed.2d 772 (1964).
Taxing authorities have lien rights. The federal government can and will file a tax lien for unpaid taxes. Such a tax lien will only cover property acquired by a debtor before a bankruptcy case is filed. However, if the IRS has filed a lien, even though the tax may be dischargeable, it will still be subject to secured treatment due to the lien. This can mean various things based on what the lien attaches to and what equity the taxpayer has in the property attached. There are a few creative ways to deal with tax liens in consumer cases, including redemptions under Section 722 of the Bankruptcy Code. However, the general rule is that once a tax lien is filed, the tax must be paid in full, either under a bankruptcy plan or outside of it, or the property surrendered. Note: even though a federal tax lien theoretically covers all property of the taxpayer, the IRS is not interested in regular personal property of nominal liquidation value.
Tax Returns in Massachusetts for Bankruptcy
In some states, bankruptcy debtors must produce four years of tax returns for the trustee as part of their post-filing duties. However, here in Massachusetts, normally we are only required to produced the last-filed federal tax return before the meeting of creditors in a bankruptcy case.