If you pay back income taxes (federal, state or local) you may be able to discharge them in bankruptcy. Alternatively, you may be able to use bankruptcy to better manage the time you have to pay your taxes and the amount of interest that you have to pay.

Income taxes can be discharged if the debtor meets three fundamental requirements. For all three requirements, it is important to note that the ability to discharge taxes applies only to income taxes. It does not apply to real estate taxes, property taxes nor sales taxes.

These latter taxes are not dischargeable. Typical income taxes are the federal 1040 return that is filed by April 15 of each year unless the debtor gets an extension and the state income taxes that are also due on April 15 of each year. Additionally, some cities and local locations have their own taxes based on a person’s income.

Requirement 1 – the three year rule

The first requirement is that the tax delinquency has to be three years old or older. The due date for most tax is April 15 of each year. Taxpayers can request extensions. The extension for federal returns and most, if not all, state returns is another six months – until October 15 of the year. The tax is due for income earned in the prior year.

For example, if a debtor files a bankruptcy on July 15 of 2015, then taxes that were due prior to April 15, 2012 might be eligible for discharge (remember this is just the first of three requirements). This in turns means any income taxes due for the years 2011 and before meet the first test. If however, a debtor filed for an extension of the 2011 return (due April 15, 2012), then the taxes wouldn’t be due until October 15, 2012. Because the due date would now be less than years from the bankruptcy filing date, the 2011 couldn’t be discharged.

Requirement 2 – the two year rule

The debtor is supposed to file a tax return and pay the taxes by the 15th of each year (unless an extension was requested and approved). The 15th of April or October is the typical due date. Many debtors don’t actually file their return on the due date. Most debtors try to file the return before the due date. Some however, do not get around to filing the tax return until well after the due date.

The two year rule allows the Bankruptcy court to discharge only debts where the return was filed 2 or more years before the filing date. To return to our example, if a debtor files a bankruptcy on July 15, 2015 and wants to discharge taxes that were due before April 15, 2012 – the debtor has to be able to show that the tax returns for 2011 and any prior year were filed within two years of the bankruptcy filing date. This means the debtor has to actually have filed the tax returns prior to July 15, 2013.

If the debtor filed the tax returns after July 15, 2013, then the income taxes cannot be discharged. If the tax returns were filed before July 15, 2013, then the Bankruptcy Court will look to the third requirement.

Requirement 3 – the 240 day rule

When a taxpayer files a tax return, there is often money due. The taxing authority (federal, state or local) will review your return. If there is money due, the taxing authority will assess (put the details of the amount due on their tax records/books). The assessment date is normally a few months after the return is filed. Additionally, sometimes debtors enter into an agreement to pay taxes or the taxing authority does an audit of your income taxes. The agreement or the audit may extend the actual assessment date.

The third requirement is that the assessment has to be more than 240 days (about eight months) from the bankruptcy filing date. Returning to our example, if the debtor files a tax return on July 15, 2015 then the tax assessment that the debtor wants discharged must have been filed 240 days before July 15, 2015 – somewhere around November 15, 2014.

If the debtor’s request for a tax discharge fails any one of these three tests, the income tax cannot be discharged. If the debtor’s request for discharge passes all three tests, then the debts can be discharged and the interests and penalties that directly relate to these income taxes can also be discharged.

There are exceptions

Discharging the debt does not remove the tax lien. If the taxing authority obtained a tax lien before you filed for bankruptcy, then even if you meet the three requirements your assets will be subject to the tax lien. If you have tangible assets, the taxing authority may try to sell them to pay the tax lien. The authority may also try to attach some of your wages.

The three year, two year, 240 rule does not apply to taxes if the taxpayer was trying to willfully evade taxes or had committed tax fraud. These types of scenarios will prevent the debtor from having his/her income taxes discharged. The three requirement rule is meant to help debtors who honestly ran into financial difficulties.

Taxing authorities are bound by the relevant Statute of Limitations. The taxing authority must bring a claim within a preset time or they won’t be able to demand that you pay your taxes. Failure to claim taxes within the Statute of Limitations is a defense that can be used in bankruptcy and outside of bankruptcy.

There are different rules for property taxes and some of the other taxes like Medicare and FICA taxes. Speak with your bankruptcy lawyer to see if these debts can be discharged.

What happens to my tax refund during bankruptcy?

During the first part of any year, personal bankruptcy filings become more interesting due to income tax refunds. Most people never think about it, but your tax refund accrues during the year. The amount that you are owed, and, consequently, the amount the bankruptcy estate is entitled to receive, is a percentage based on the day that you file your bankruptcy case, but once December 31 passes, the taxpayer is entitled to 100% of any refund, and this money is property of a debtor’s bankruptcy estate.

The Chapter 7 trustee can take your refund

It seems axiomatic that the trustee can’t take what you don’t have, but that’s not the case with income tax refunds. There is no requirement for the “present possession” of property before turnover can be compelled under Section 542 (See Newman v. Schwartzer, 487 BR 193 (9th Cir BAP 2013)). In Newman, the 9th Circuit BAP held that a Chapter 7 trustee could compel a debtor to turnover a pre-petition tax refund even though the debtor had spent the entire refund before entry of the turnover order.

The tax refund constituted property of the estate as “an interest in property” as of commencement of the case. The fact that the debtor had spent the refund prior to the turnover order did not defeat the trustee’s right to compel the turnover, because the refund constituted property in the debtor’s “possession, custody or control” during the case, and, pursuant to Bankruptcy Code Section 542, the debtor must account to the trustee for either the property or its value.

The moral of this case? Don’t spend a tax refund you receive after filing until you are sure the trustee has abandoned it.

Spend it before filing

The safest way to avoid the problem in Newman is to file your tax return and receive your refund prior to filing bankruptcy. The bankruptcy estate is calculated as of the date that you file your case. If the tax refund money is gone on the date you file your bankruptcy, there is generally no way for the bankruptcy trustee to make a claim against the tax money.

Because you are spending a great deal of money in a short period of time, you need to consult with experienced counsel. In many cases you can exempt all or a portion of your tax refund, so you can keep the cash after you file bankruptcy. If your exemptions will not protect all of your income tax refund, you should consider spending the difference to benefit your family. The best guidance is to spend the money on goods or services that are reasonably necessary living expenses. The following categories are generally safe:

  1. Household expenses such as utility bills, mortgage or rent payments, car payment, auto insurance, and needed auto repairs/tires
  2. Personal expenses such as food and clothing, dental work, and medicine
  3. Priority debts like child support arrears and tax debts
  4. Attorney and bankruptcy fees

Luxury good purchases like electronics, vacations, and jewelry should be avoided, as should gifts to family members or friends, spending sprees, and gambling. Also, avoid making payments for months in advance. The trustee may consider these payments part of the bankruptcy estate. This bears reiterating: the best course is to discuss any payment from your tax refund with your attorney beforehand.

Shield it

Even if you are not able to exempt your tax refund, you may be able to save your refund under certain circumstances. One trick to apply the non-exempt portion of your expected income tax refund to next year’s taxes. The IRS will keep your tax over-payment and use it for taxes you may owe in the future. The Tenth Circuit case of Weinman v. Graves, 609 F.3d 1153 (10th Cir. 2010) holds that the bankruptcy trustee cannot force the IRS to turnover a tax refund that is held to pay future taxes. The election to apply the refund to your future tax liability is irrevocable under section 6513(d) of the Internal Revenue Code. Consequently, your interest in the refund when you file bankruptcy is limited to what is left after the IRS applies the money to next year’s tax liability.

This trick is common in Chapter 7 cases, but can be used in Chapter 13 cases as well to avoid increasing your monthly plan payment. Working closely with skilled tax professionals will maximize the amount of money you get to keep. If you are expecting a large income tax refund, but need to file Chapter 13, speak with an experienced bankruptcy attorney and discuss your options.

If your tax refund is largely due to an Earned Income Tax Credit (EITC) or Child Tax Credit, you may be able to exempt and keep some or all of it by using a state specific exemption for public assistance benefits. Currently, Florida and Indiana have state exemption laws that fully protect EITCs.

Finally, filing separately may protect all or part of a joint tax refund. Whether a joint refund is part of a debtor’s bankruptcy estate when filing separately depends on ownership rights under state law.

Chapter 13 and taxes

In a Chapter 13 bankruptcy, the debtor is required to devote all disposable income to the repayment of debt. Most bankruptcy trustees and courts consider tax refunds part of the debtor’s disposable income that is over-withheld and should be paid into the Chapter 13 plan. However, instead of reducing the amount payable under the debtor’s plan, tax refund money is paid to unsecured creditors that would otherwise not be paid. If the debtor is paying a 100% repayment plan, the trustee will not request turnover of any tax refunds.

Keeping your money and avoiding an income tax turnover during a Chapter 13 case may be as simple as adjusting your pay-check withholding. By speaking to a tax professional you may be able to predict your tax liability and put more money in your pocket each payday. However, be careful to avoid a situation where you do not withhold enough taxes and end up with a large tax bill at the end of the year.

If you have any questions about your tax return during bankruptcy proceedings, feel free to send us an email using our contact page and we’ll respond to you in the most timely manner.

Some debtors may file a Chapter 13 to save their home or other secured assets. Taxes are treated like unsecured debts if they meet the three year, two year, 240 day tests. If they don’t then they are treated like priority claims which must be paid through the bankruptcy plan.

The main benefit of a Chapter 13 bankruptcy, if the taxes can’t be discharged, is that the debtor will have three to five years to pay them off. While interest and penalties acquired before the filing date will also have to be paid, interest will not further accumulate during the plan period.