You can get rid of tax obligations in bankruptcy...if certain conditions are met.

With tax day rapidly approaching, I will undoubtedly see an increase in the number of calls to my office with questions about getting rid of tax debts via bankruptcy. The ability to walk away from income tax obligations are contingent on several requirements being satisfied (withholding taxes and other "trust-fund taxes are not eligible for discharge and carry very large penalties and interest -- sometimes up to 50% of the tax owed so don't mess around with sales, withholding, and other similar taxes as the consequences can be serious and very costly).

The first couple of requirements are to be expected...the return must be truthful and the taxpayer must not be guilty of tax evasion. It goes without saying that in order to benefit from the protections included in the bankruptcy code with respect to income tax obligations the taxpayer must have filed an accurate and truthful tax return. You cannot commit tax fraud and then expect to walk away from the debt. The same logic applies to someone guilty of tax evasion. You cannot be found guilty of such a crime and then expect to discharge the debts in a bankruptcy proceeding.

Now for the technical requirements. First, the due date for the returns in question must have been at least three years prior to the date of the bankruptcy filing. For instance, if you file bankruptcy May 1, 2009, the taxes you want to discharge must have been due before May 1, 2006. Thus, any personal income taxes from years 2005 and earlier would be eligible for discharge assuming they meet the other criteria.

Second, the tax returns in questions must have been filed at least two years earlier than the bankruptcy filing date. Using our example above, if you file bankruptcy May 1, 2009 and you want to discharge your 2005 tax liability, which would have first become due on April 15, 2006 (assuming no extensions were filed) but you did not file the actual return itself until May 2, 2007, you would not be able to discharge those taxes. While the due date would have been more than three years before the date of filing, the return would not have been on file for at least two years, This is an excellent example of how important planning can be when it comes to filing bankruptcy. This is also a great reason to be sure you file your tax returns on time every single year. If you don't file the returns, you cannot discharge the debts ever.

The third requirement is that the tax assessment must be at least 240 days old. This requirement can be a technical issue within the taxing authority itself. This is typically not a problem for most people. Instead, failure to timely file the returns is what normally prevents a debtor from being able to discharge their tax obligations. For most people who file their tax returns on time, they will be able to walk away from income tax obligations which fall outside of the three year window. The reason is that if the return was timely filed and the three years have passed, the return, by the very nature of the timely filing, has been on file for more than two years and the assessment has typically occurred long before the 240 day window.

The next logical question is "what happens to the debts that aren't eligible for discharge"? First, the IRS will have to wait to pursue you until your case is discharged. Thus, Uncle Sam will have to cool his heals for about four months. These taxes will be given a priority designation by the Court and will be paid from any non-exempt assets after the payment of secured claims and/or any higher priority claims. If, and this usually does not happen, there are sufficient assets from which to pay the taxes which survive the discharge, they will be paid by the Trustee. Normally, there are not any assets with which the Trustee can pay the priority taxes. This means the debtor will still owe the non-dischargeable taxes after the bankruptcy case is concluded. If necessary, the debtor could wait the necessary time period (four years) and file a Chapter 13. If the debtor can't afford to wait four years because of the pressure from the IRS, the debtor can still file a Chapter 13 so long as he proposes to pay 100% of the tax obligation over the life of the plan.

Please note that the same guidelines are true for state income taxes as well. I refer to the IRS in the above discussion but that is only for simplicity purposes. You can discharge income taxes owed to the Indiana Department of Revenue as well assuming you meet the criteria.

Lastly, while I have tried to simply things for you in this blog post, the tax and bankruptcy codes are very complex. Thus, it is important for me to review each debtor's case in detail to better understand which taxes are eligible for discharge.