Debtors may be able to discharge some or all of their older income tax obligations in bankruptcy. Dischargeability of these taxes turns on the question whether or not they are “priority” claims. Tax obligations that are non-priority are dischargeable.
Taxes that are given Priority Status
The Bankruptcy Code gives the following types of federal, state and local taxes priority:
- income taxes which are less than three years old, computed from the date the return was due, not the end of the tax year;
- any withholding tax for which the debtor is liable in any capacity; other employment related taxes if within three years of the filing date;
- excise taxes which are less than three years old;
- certain customs duties; and
- any pecuniary loss penalty on any of the above types of taxes.
When Taxes Lose Priority Status
The Bankruptcy Code provides that taxes assessed by a governmental agency which are based on income lose their priority status when the following occurs:
- the tax return, with all extensions, was due more than three years prior to filing for bankruptcy protection;
- a return was filed at least two years prior to the filing for bankruptcy relief;
- the tax obligation was assessed at least 240 days prior to filing; and
- the taxpayer is not guilty of fraudulent conduct or tax evasion and has not signed an offer in compromise or other settlement agreement.
The following taxes are dischargeable:
- tax penalties for non filing, late payment, late deposit, fraud penalties and late estimated payments if the taxes to which they relate are dischargeable;
- income taxes that are over three years old, have been filed at least two years prior to the petition, and/or have been assessed as an audit deficiency for at least 240 days; and
- estate and gift taxes which are over three years old.
Dischargeability of Penalties and Interest
Certain penalties and interest may also be dischargeable. Penalties designed to compensate the agency for actual loss are non-dischargeable while those that are punitive in nature may lose priority and become dischargeable. Employment taxes are not dischargeable regardless of the age of the tax claims. This is true whether the obligation arose because the debtor was the employer or a responsible officer.
Stopping IRS Collection Procedures
Bankruptcy protection also provides a means to stop IRS collection procedures for a period of time while payments are made. The provision of the Bankruptcy Code that grants debtors automatic relief from collection activity applies to the IRS in the same manner as other creditors. The period of relief depends on many factors, including whether the taxpayer files for relief under Chapter 7, 11 or 13. Priority and non-priority taxes can be treated in a Chapter 11 or Chapter 13 plan and paid out over time. The bankruptcy stay remains in effect until the plan is completed or the case dismissed. This may allow a business that has been seized by the IRS to re-open and operate under a Chapter 11 plan without interference from the IRS or other creditors. The filing of a Chapter 7 stays all collection proceedings until the entry of a discharge or dismissal of the case.