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Bar News - July 15, 2015

Federal Practice & Bankruptcy: Discharging IRS Liabilities in Bankruptcy: The Importance of Timing


Today is July 17, 2015. A longtime client named Susan walks through your office door. She tells you she didnít file her 2011 and 2012 federal income tax returns until June 1, 2013, and now has $15,000 in liability with the Internal Revenue Service for those two years Ė $9,500 for 2011 and $5,500 for 2012.

These figures resulted from Susanís underpayment of the tax due as stated on her returns. The underpayment, in turn, was a product of inadequate withholding throughout 2011 and 2012. By the time she filed her returns, she lacked the funds to pay the amounts due.

Susan asks whether or not bankruptcy is a viable option to resolve her federal income tax debt. You can inform her that, even if the federal tax liabilities are dischargeable in bankruptcy, filing for bankruptcy may not necessarily be the best option to resolve her tax debts. Other options include administrative remedies within the IRS, such as an offer in compromise, an installment agreement, or a request for abatement of penalties. You can help your client evaluate the choices before rushing into a bankruptcy case.

The starting point for such an evaluation, however, is determining whether thereís even a possibility of discharging the tax liabilities in bankruptcy. To answer this question, you will need to apply the ď3-2-240 rules.Ē The 3-2-240 rules are the three major rules that dictate which taxes can and cannot be discharged in bankruptcy.

The first, known as ďthe three-year rule,Ē states that, for a tax to be dischargeable, the tax return the debt arises from must have been due at least three years prior to the time of petitioning for bankruptcy.

Then, the two-year rule states that the tax return at issue must have been filed at least two years prior to petitioning for bankruptcy. IRS-prepared substitutes for return do not count. The last of the three major rules, the 240-day rule, states that the IRS must have assessed the tax at least 240 days before the date the bankruptcy petition is filed.

In applying these rules to Susanís tax debts, it is important to evaluate each year separately. First, we address her 2011 liability. Unless she requested an extension, her 2011 return was due April 17, 2012. Fortunately for Susan, this was more than three years ago. Accordingly, her 2011 liability meets the three-year rule.

Next, we apply the two-year rule. Susan filed her 2011 return on June 1, 2013, which was more than two years ago. Therefore, she passes the two-year rule, as well.

Finally, we look at Susanís 2011 liability in light of the 240-day rule, which turns on the date of assessment. To determine that date, you can order an account transcript for your client from the IRS. Here, however, it is safe to assume that Susan meets the 240-day rule. Her 2011 tax liability is not the result of an audit; rather, the assessment arose from her late-filed return Ė a self-assessment. Accordingly, the assessment date is likely to have been shortly after the date of filing. So, all of Susanís 2011 debts are probably dischargeable.

Now, for 2012, we repeat the same process: evaluate her debts against the 3-2-240 rules. Unfortunately, Susanís 2012 tax debts are not dischargeable yet, under the three-year rule, because three years have not yet passed since the due date of her 2012 return, April 15, 2013.

However, it should be noted that Susanís debts from 2012 are compliant with the two-year and 240-day rules. Therefore, unless Susan is content with possibly eliminating only $9,500 of her total debt, you could advise her to hold off on petitioning for bankruptcy until next spring.

Given that today is July 17, 2015, and her 2012 tax debts may become dischargeable on April 15, 2016, she could choose to wait the few months required for the possibility of discharging the full $15,000.

In conclusion, always keep timing in mind when it comes to bankruptcy. If you are not careful, you may miss out on an opportunity to dispose of a debt. As can be seen with Susan, the difference between filing now versus a little while down the road could make a huge difference.

Simon Levenson is an intern at the NH Bar Association Low-Income Taxpayer Project, a free clinic for low-income taxpayers facing controversies with the Internal Revenue Service. He is an accounting and global perspectives student at Bentley University. He thanks his supervisor, LITP Coordinator Barbara Heggie, for her assistance with this article.

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