June 20, 2019

Chapter 7 Income Tax Relief Difficult for Tardy Filers

People in financial hardship often need income tax relief. Contrary to what many people believe, income taxes can be dis-chargeable in a Chapter 7 bankruptcy case.  “Dis-chargeable” means certain income taxes will cease to exist just as other debts.

A three-point test to discharge taxes in Chapter 7 bankruptcy

In order for tax debt to be dischargeable, the taxes must meet a three-point test:

  • First, the tax must be for a year for which the return was due plus any applicable extensions at least three years before the bankruptcy filing.
  • Second, a tax return for the particular tax year sought to be discharged must have been filed at least twoyears before the bankruptcy filing.
  • Third, the taxes must have been assessed at least 240days prior to bankruptcy filing.

There have been several Bankruptcy Court and Circuit Courts of Appeals decisions over the last few years that have dealt with the second point mentioned above: namely, when the return is filed. These cases have dealt with the question of the effect of the Internal Revenue Service filing a substitute for return (“SFR”) for a taxpayer who has not filed returns.

An SFR essentially is the way that the Internal Revenue Service can file a return for a taxpayer and assess tax when it does not have an actual return. A number of the court decisions that have considered the issue have held that an SFR does not satisfy the tax return filing requirement that is set out in the second point set out above. In other words, an SFR that has been processed and assessed is not a tax return for purposes of a bankruptcy discharge. The taxpayer’s subsequently filed return will not qualify as a filed return under the two year rule in bankruptcy.

Enter a Supreme Court verdict

Thus far, the Internal Revenue Service had not pushed this issue in a broad sense; however, the tide has now turned. The Internal Revenue Service has now issued a policy statement indicating that it will not consider a tax return after an SFR has been filed as atax return for the purpose of bankruptcy discharge. This applies to most taxpayers. For all practical purposes, this is now the law and only a decision by the United States Supreme Court will change it.

For people who are delinquent in filing tax returns who have insurmountable tax debt, there had been hope. If the taxpayer files the return and waits two years, the taxes will be dischargeable. Now, if the Internal Revenue Service beats the taxpayer to the punch by filing an SFR, the taxes will not be dischargeable in bankruptcy.Unfortunately, it can reasonably expect that the Internal Revenue Service will be filing more SFRs and will file them quicker. This means that more and more taxpayers will not have bankruptcy relief as an option.

Chapter 13 bankruptcy is a wholly different matter, one that is best covered in a bankruptcy counseling session.