The Basics of Bankruptcy and the IRS.
Bankruptcy is one of the tools we discuss in our Atlanta CPA firm with clients who are burdened by back taxes that they cannot afford to pay. Bankruptcy does offer tax relief, but with some critical rules and significant exceptions. It is important that taxpayers understand how these rules and exceptions work.
Bankruptcy offers a number of advantages:
- IRS collection activity stops
- Possible discharge of taxes, interest and penalties
- Forcing the IRS to accept payment arrangements
There are also disadvantages:
- Legal costs
- Damage to credit score
- Potential stigma
Stopping the IRS
The Bankruptcy Code provides that all collection activity by creditors stops once bankruptcy is filed. This is called an “automatic stay” and includes the IRS and the state department of revenue. IRS tax levies will stop. The taxpayer gets immediate relief, and time, to work out a plan for back taxes. And the IRS is forced to go along with the deal.
Requirements for Discharging Taxes in Bankruptcy
Discharging a federal tax in bankruptcy depends on a series of 10 factors. These factors include the type of tax, the numbers of years the tax has been outstanding, when the return was filed and what the taxpayer has done since filing the return.
Here is a summary of the rules that must be followed for a tax to be discharged in bankruptcy:
- The tax must be more than three years old, dated from the most recent date the tax return was due to be filed. This is typically April 15 of the following year, or the extension date. The date that the return was actually filed with the government does not matter.
- The tax must have been assessed more than 240 days prior to the bankruptcy. If the taxpayer requested an offer-in-compromise, the period that the offer was pending is added to the 240 days, plus another 30 days.
- A late-filed tax return must have been filed with the government more than two years before the bankruptcy petition date.
- The return for the tax year in question must be non-fraudulent.
- A taxpayer must have not willfully attempted to evade taxes (the non-tax evasion rule).
- Income tax must be assessed as of the bankruptcy petition date and must not be assessable post-petition (the unassessed income tax rule). This excludes additional taxes assessed by an audit, even if the underlying tax is dischargeable.
- Federal and state payroll withholding taxes and sales taxes may not be discharged.
- Property taxes are dischargeable in bankruptcy only if they are assessed and payable without penalty more than one year before the petition date.
- Gift taxes, estate taxes and highway use taxes imposed within three years of the petition date may not discharged.
- Tax claims that arise after a taxpayer is forced by creditors into an involuntary bankruptcy but before a bankruptcy trustee is appointed or before the order for relief is granted (gap claims) may not be discharged.
Credit Cards Do Not Help
If a non-dischargeable tax is paid with a credit card, the portion of the credit card balance relating to the tax is not dischargeable in bankruptcy.
Penalties and Interest on Back Taxes
Penalties that are designed to repay the government are non-dischargeable in bankruptcy. This includes the “Trust Fund Recovery Penalty” relating to payroll taxes.
On the other hand, penalties designed to punish the taxpayer may be discharged. This includes income tax penalties, such as accuracy penalties, failure-to-file penalties and failure-to-pay penalties.
Interest on tax debts follows the underlying tax. If the tax is dischargeable, then the interest is dischargeable.
A bankruptcy filing may be used to create an installment agreement with the government to pay off a tax over a period of time. This can work even if the IRS will not otherwise cooperate with the taxpayer.
Tax Liens and Bankruptcy
Federal tax liens pass through bankruptcy and attach to the taxpayer’s future interests. This means that a federal tax lien remains even after a tax is discharged in bankruptcy. The assets covered by the lien are still subject to IRS collection.
In situations where the taxpayer is concerned about the risk of collection on liens after bankruptcy, an offer-in-compromise may be used to address this problem.
Bankruptcy is a tool to resolve debts, including some (but not all) tax debts. It represents one of the available solutions to provide tax relief. The other solutions are the offer-in-compromise, uncollectable status and the installment agreement or payment plan.
When evaluating bankruptcy as an option to resolve taxes, a qualified bankruptcy attorney should be consulted to determine if the taxpayer meets all the qualifications. These rules are complicated and vary according to the federal circuit in which the taxpayer resides.
A careful analysis of IRS tax transcripts should also be performed, either by an attorney or an experienced CPA or tax advisor. This is necessary in order to know what the IRS has in its records that could impact qualification under the bankruptcy provisions.
Feel free to reach out to my CPA firm to discuss issues relating to back taxes, tax preparation, tax planning and accounting for small businesses. Our office is in the Buckhead – Sandy Springs area of Atlanta, which is an advantage to those looking for a local firm to handle their tax matters.
Founded by Gary Massey, CPA, Massey and Company is a boutique CPA firm located in Atlanta, GA, serving the needs of small businesses, business owners and individual taxpayers. Our services include tax preparation, tax planning, taxpayer representation, IRS audits, monthly bookkeeping and accounting.