As part of my bankruptcy practice, I strive to stay current on North Carolina Department of Revenue (NCDOR) and IRS policies that may affect my clients.
A three-point test to discharge income taxes in Chapter 7 bankruptcy
In order for income 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, the taxpayer must have filed at least two years before the bankruptcy filing, a tax return for the particular tax year sought to be discharged.
- Third, the taxes must have been assessed at least 240 days prior to bankruptcy filing.
Certain events may extend these time periods. Further, one thorny issue we see among our clients is the dreaded substitute for return (“SFR”) for a taxpayer who has not filed returns.
What’s an SFR?
An SFR is a return that the IRS prepares and files only on information that the IRS has from other sources, such as the taxpayer’s W-2 issued by an employer. It will not reflect additional exemptions or expenses that may lower the taxpayer’s tax liability. More importantly, an SFR does not satisfy the tax return filing requirement that is set out in the second of the three-point test 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.
NCDOR tax liability following an IRS assessment of additional tax owed
One trap for the unwary arises when (1) a taxpayer files a federal and North Carolina income tax return, (2) the IRS examines the return and assesses additional tax owed, and (3) informs the NCDOR of this information.
This prompts the NCDOR to inform the taxpayer, in writing, advising of the increased state tax owed and requesting that the taxpayer file amended returns. If the taxpayer fails to file an amended North Carolina return reflecting the increase in tax, the NCDOR’s policy is to assess the additional tax based on the IRS information, and treat the assessment as if no return was ever filed.
This is critical because the increase in North Carolina tax cannot be discharged in a bankruptcy case because no return was ever filed, whereas if an amended North Carolina return is filed, the additional income tax can be discharged in a bankruptcy case at the appropriate time, pursuant to the bankruptcy code’s provisions about the dischargeability of income tax. In contrast, the IRS’s current policy is that once an SFR is finalized, the resulting debt can never be discharged in a bankruptcy case (not even following the filing of an amended federal tax return).
The lesson here is that taxpayers should always strive to file tax returns, and avoid an SFR at all costs.
This can make a big difference in the remedies available to a taxpayer pursuant to the bankruptcy code. In practical terms, this means that a client who did not file an amended North Carolina return following an assessment based on information from the IRS (whether from an audit or otherwise) will face the choice of filing an amended state return and waiting at least two years to discharge those taxes in a bankruptcy case, or filing now and being stuck with the additional tax owed because of the assessment.