August 11, 2018

Discharging Unpaid Taxes in Bankruptcy

Tax Relief Articles

Houston Tax Attorney

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There are circumstances when unpaid taxes can be discharged in bankruptcy.  There are a number of rules involved.  They all hinge on whether a tax return was filed.  The recent United States v. Mayer, No. 16-626-RGA (D. Del. 2018), case provides an opportunity to consider these bankruptcy-tax rules.

Facts & Procedural History

The case involved the taxpayer’s Form 1040 for the 2003 tax year.  The taxpayer failed to file the tax return timely.  The tax return should have been filed by April 15, 2014.

Because the taxpayer did not timely file his tax return, the IRS prepared and filed a substitute for return for the taxpayer.  The IRS did this on November 17, 2005.  The taxpayer filed the tax return on February 22, 2007.

The taxpayer filed bankruptcy and a discharge order was entered on March 8, 2016.

When the IRS attempted to collect the taxes, litigation ensued.  The taxpayer argued that the unpaid taxes had been discharged in bankruptcy.

Discharging Taxes in Bankruptcy

Unpaid Federal taxes can be discharged in bankruptcy in some circumstances.  There are a number of rules that apply.  These rules say that Federal income taxes cannot be discharged if:

  1. The due date of the tax return is within three (3) years of the date of the bankruptcy petition (“3-year rule”);
  2. The assessment date is within 240 days of the date of the petition (“240-day rule”);
  3. A tax is assessable, but not assessed (in certain circumstances);
  4. The tax return was filed within two (2) years of the date of the petition or not filed at all (“2-year rule”); or
  5. The debt was incurred due to fraud.

Note that each of these rules relate to the filing of a tax return.  But what if a tax return was filed late?  This brings us to the rules in the Mayer case.

The Courts: No Discharge for Late Filed Tax Returns

The courts have generally concluded that taxes are not discharged in bankruptcy if the taxpayer did not file a timely tax return.  The courts have reached this conclusion by finding that late-filed tax returns are not actually tax returns under the bankruptcy discharge rule.  This is what the court relied on in Mayer to conclude that the the unpaid taxes were not discharged.

The IRS: No Discharge if IRS SFR

But the IRS takes a different approach.  It considers whether the taxpayer filed a late return before the IRS prepared a substitute for return (“SFR”).   A SFR is a tax assessment made by the IRS if the taxpayer does not file their own tax return.  Think of it as an IRS-prepared tax return.

In Mayer, the IRS prepared a SFR and the taxpayer filed his tax return long after the SFR date.  Had the taxpayer filed his return prior to the time the IRS prepared the SFR, the IRS may have considered the taxpayer’s unpaid taxes to have been discharged.  Because the taxpayer did not file his return within this window of time, the IRS did not treat the taxes as having been discharged.  This left the taxpayer with no option, other than paying or making other arrangements for the unpaid taxes).

The lesson is that unfiled tax returns should be filed ASAP, particularly if there is any possibility that the taxpayer will need to rely on the fresh start from bankruptcy to deal with their unpaid tax liability.

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