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1. Income Taxes (Federal and State)


1. Income Taxes (Federal and State).  An "income tax" is any tax (federal or state) measured by gross income or gross receipts. Income tax debts can be discharged in bankruptcy, but only if the tax is more than 3 years old and satisfies several other legal requirements. You must analyze the dischargeability for each tax year in question to determine whether an income tax debt can be discharged in bankruptcy. A tax is dischargeable only if all of the following requirements are met for each tax year.       Index

1.1. Three Year Age Rule. More than 3 years must elapse between the bankruptcy filing date and the date the income tax return was last due, including all extensions.       Index

Example #1.1. Assume that Taxpayer fails to request an extension of the due date to file his 2012 income tax return.  Any tax owed for 2012 can not be discharged in bankruptcy unless the bankruptcy petition is filed on or after April 16, 2016.

1.1.1. Return Filing Extensions. The 3 year time period does not expire until the due date for filing the tax return. For federal income taxes, if no extension is requested, the 3 year time period will elapse on April 15 of the 3rd year following the tax year in question. If an automatic extension is requested, the 3 year time period will not expire until the last date of the extension period (October 15).        Index

Example #1.2. On April 10, 2012, Taxpayer requests a 6 month automatic extension of time to file his 2012 tax return. He files the return on or before the due date (October 16, 2012), but does not pay any portion of the unpaid tax. The 2012 income taxes can not be discharged in bankruptcy unless the bankruptcy petition is filed on or after October 16, 2016.

1.1.2. Due Date Controls – Not Filing Date. The last due date for filing the return is the proper date for determining if the 3 year age rule has been satisfied. The date the taxpayer actually files the return is irrelevant.        Index

Example #1.3. On April 10, 2012, Taxpayer requests an automatic extension of time to file his 2012 tax return, which makes the return due on October 15, 2012. It is irrelevant to the 3 year age rule whether Taxpayer actually files the return early (prior to October 15, 2012) or late (after October 15, 2012). Any tax owed will be discharged only if the bankruptcy petition is filed on or after October 16, 2016.

1.2. Two Year Filing Rule. To discharge a tax debt in a Chapter 7 case, the taxpayer must file the return more than 2 years before the date that he files for bankruptcy. Although the 3 year rule considers the age of the tax, the 2 year rule only deals with the actual filing date of the return.        Index

1.2.1. IRS Filed Returns Do Not Qualify. The Internal Revenue Code contains a rule (IRC § 6020(b)) that permits IRS to file a return for a taxpayer, from information it already has available, if the taxpayer fails to file his own return in a timely manner. The IRS return is commonly referred to as an "IRS substitute return." These returns are often filed by IRS when a taxpayer fails to file a return if IRS has W-2, 1099, K-1 or other data that indicates the amount of income earned during a particular tax year.

If IRS prepares a return, the taxpayer can consent to the return by signing it, or the IRS can file the return without the taxpayer’s consent. If the taxpayer does not sign or otherwise agree to an IRS filed return, the IRS return does not count as a filed tax return for purposes of the 2 year filing rule. However, if the taxpayer signs or consents to to the IRS prepared return, the IRS return will count as a filed return for purposes of the 2 year filing rule.        Index

Example #1.4. Taxpayer never filed a 2010 income tax return. On January 2, 2012, IRS files a substitute return on behalf of Taxpayer. The substitute return specifies a $500,000 tax liability. IRS assesses the tax on the same day. Taxpayer does not sign or otherwise consent to the filing of the return. If Taxpayer files for Chapter 7 bankruptcy on January 1, 2014, he can not discharge the 2010 tax debt because he never satisfied the 2 year filing rule. In fact, the 2010 taxes can never be discharged in a Chapter 7 case because Taxpayer never filed and signed a tax return.

1.2.2. Filing Date for Purposes of 2 Year Rule. Federal tax returns filed before the due date are not considered filed until the due date. Returns filed after the due date are considered filed on the date IRS actually receives the return. If the taxpayer files the return before the due date, the 2 year time period starts to run on the due date, not the actual filing date. If the taxpayer files the return late (after the due date), the 2 year time period starts to run on the date that IRS actually receives the return.        Index

Example #1.5. Taxpayer ignores the April 15, 2012 deadline for filing his 2011 tax return. He waits until May 1, 20013 (one year and 15 days after the due date) to mail the return. IRS does not receive the return until May 15, 2013. IRS immediately assesses the tax after it receives the return. The 2011 taxes will not be dischargeable in a Chapter 7 bankruptcy unless Taxpayer files for bankruptcy on or after May 16, 2015.

1.2.3. The McCoy Decision. In 2012, the Fifth Circuit Court of Appeals issued a controversial opinion which, if followed by the IRS, would eliminate a debtor's ability to discharge all income tax debts in cases where the taxpayer files a return late by even one day.  In McCoy v. Mississippi State Tax Commission, the debtor owed unpaid state income taxes for 1998 and 1999. She filed for Chapter 7 bankruptcy in 2008. The tax debt in question clearly satisfied the 3 year, 2 year and 240 day rules. Approximately 1 year after the discharge order was granted, the debtor filed a lawsuit in bankruptcy court requesting a declaration that the tax debt was discharged in the prior bankruptcy case. The State of Mississippi argued that: (a) the state income tax returns file were filed late, and as a result, did not qualify as "tax returns" as defined by 11 U.S.C. § 523(a)(*), a provision added to the Bankruptcy Code as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"); and (b) as a result, Ms. McCoy’s income tax debts to Mississippi could not be discharged in bankruptcy. In other words, the State of Mississippi argued that filing a return late is the same as never filing it at all.  The Fifth Circuit agreed and held that a late filed income tax return filed by the taxpayer (rather than the IRS) can never qualify as a return for bankruptcy discharge purposes.        Index

In Hernandez, 2012 Bankr. LEXIS 101 (Bankr. W.D. Tex. 1/11/12), a case decided only one week after McCoy, a San Antonio Bankruptcy Court applied the reasoning of McCoy to federal income tax debts and the Internal Revenue Code. The Court stated that "[a]lthough the McCoy holding applied to a state tax regime, its logic applies with equal (if not greater) force to the federal taxing scheme."

The practical effect of McCoy is to completely eliminate the two year return filing rule. The McCoy decision has been correctly criticized as "just plain wrong" (See, Yet Another Hanging Paragraph Creates a Taxing Situation, Stephen W. Sather, January 20, 2012). McCoy is wrong primarily because it contradicts a basic rule of statutory construction – a Court may not construe the text of one statute so that other text in the same statute is rendered completely meaningless. The McCoy decision does just that. If a tax reported in a late filed tax return can never be discharged, then the 2 year return filing rule, which permits the discharge of taxes reported in tax returns filed more that 2 years before the bankruptcy is filed, can never have any meaning or application.

1.2.4. The IRS Administrative Rule – The Back Door Approach. The McCoy decision is binding precedent in every federal court located in the Fifth Circuit (all courts in Texas, Louisiana and Mississippi). Under McCoy, income taxes can never be discharged in bankruptcy if the taxpayer files his return late by even one day. However, the IRS does not follow the McCoy decision, even for bankruptcy cases filed in the Fifth Circuit. This oddity has provided a backdoor approach that will enable a taxpayer to get the IRS to write off tax debts even if the taxpayer files a tax return late.        Index

Yes, you read that correctly. The McCoy decision, if followed by IRS, would legally permit IRS to refuse to recognize the bankruptcy discharge for any tax debt involving a late filed return. But the IRS official position disregards the McCoy decision entirely and substitutes its own more lenient rule. This official position is spelled out in detail in several official notices issued by the Office of Chief Counsel, as follows:

Litigating Position Regarding the Dischargeability in Bankruptcy of Tax Liabilities Reported on Late-Filed Returns and Returns Filed After Assessment dated September 2, 2010;

Reissuance of Determining Dischargeability of Late Filed Returns in Which a Substitute for Return was Prepared under IRC § 6020(b) dated June 28, 2013; and

Reissuance of Determining Dischargeability of Late Filed Returns in Which a Substitute for Return was Prepared under IRC § 6020(b) dated June 12, 2014.        Index

The IRS administrative rule works as follows: If the tax debt meets the requirements of the 3 year, 2 year and 240 day rules, IRS will still administratively discharge (write off) the tax debt so long as the taxpayer files his own tax return before IRS files a substitute return.  This rule applies regardless of whether the taxpayer files his return late. If the taxpayer files a tax return late and IRS never files a substitute return, IRS will ignore the McCoy decision and write off the tax debt if the tax debt otherwise satisfies the 3 year, 2 year and 240 day rules.  On the other hand, if the taxpayer fails to file his return in a timely manner and IRS then files a substitute return, IRS will not write off any portion of the tax debt assessed as a result of the IRS substitute return.       Index

The taxpayer can not completely cure the situation by filing his own tax return after IRS files a substitute return. However, a taxpayer can help the situation by filing a return after an IRS substitute return if he owes more tax than that specified in the substitute return. If a taxpayer files a return that does not report any additional tax after IRS assesses a tax based on a substitute return, IRS will refuse to write off any of the tax. If the taxpayer files a return after an IRS substitute return and the taxpayer’s return discloses additional tax, IRS will write off the additional tax reported in the taxpayer’s return.

In any court in the Fifth Circuit, the taxpayer will lose if he files a lawsuit attempting to litigate the issue. IRS would then invoke the McCoy case to defeat the taxpayer’s claim that his taxes were discharged in bankruptcy.

Example #1.6.

Facts. Taxpayers failed to file their 2003, 2004 and 2005 tax returns in a timely manner.  On November 21, 2005, IRS filed a substitute return on Taxpayer's behalf for the 2003 tax year.  IRS never filed a substitute return for the 2004 and 2005 tax years. On July 19, 2006, Taxpayers filed their own return for the 2003 tax year.  On December 4, 2006, Taxpayers filed returns for the 2004 and 2005 tax years. Taxpayers filed for Chapter 7 bankruptcy on May 16, 2015.

Result. Taxpayer met all of the requirements of the 3 year, 2 year and 240 day rules.  The bankruptcy court entered a discharge order on August 18, 2015.  IRS transcripts revealed that the remaining amount due (approx. $13,000) for the 2003 income taxes was not administratively discharged by IRS, but the remaining amount due (approx. $35,000) for  the 2004 and 2005 taxes was administratively discharged by IRS.

This is an example of a real case handled by Weber Law Firm, P.C. demonstrating that that as of October 22, 2015, IRS was ignoring the McCoy case, and is administratively discharging taxes consistent with the policy statements issued by IRS in its June 12, 2014 memorandum titled "Reissuance of Determining Dischargeability of Late Filed  Returns in Which a Substitute for Return was Prepared under  IRC § 6020(b)."  Click these links to view redacted copies of a 2003 IRS transcript indicating that an administrative discharge was not granted for the 2003 taxes, and copies of a 2004 IRS transcript and 2005 IRS transcript indicating that an administrative discharge was  granted for 2004 and 2005 taxes.

 

Example #1.7.

Facts. Taxpayer fails to file his 2010 tax return before the due date (April 15, 2011).  He also fails to request an extension of time to file the return. On January 2, 2013, IRS files a substitute tax return on behalf of Taxpayer. The substitute return specifies a $100,000 tax liability. IRS assesses the tax on the same day. Taxpayer does not sign or otherwise consent to the filing of the IRS substitute return.

Taxpayer files his own 2010 tax return on June 15, 2013. Taxpayer’s version of the return shows a tax liability of $120,000. Taxpayer’s return discloses the same income used by IRS to assess the $100,000 tax debt specified in the IRS substitute return, but also discloses additional information that results in $20,000 of additional tax described in his version of the return. IRS assesses an additional $20,000 of tax on June 30, 2013. Taxpayer files for Chapter 7 bankruptcy on September 15, 2015.

Result. Taxpayer meets all of the requirements of the 3 year, 2 year and 240 day rules. Due to the McCoy decision, IRS is not legally required to write off any portion of the $120,000 tax debt. In addition, IRS will refuse to write off the $100,000 tax debt because the substitute return was filed before Taxpayer filed his version of the return. However, IRS will write off the additional $20,000 of tax because Taxpayer’s return disclosed $20,000 in tax that was not listed in the IRS substitute return.

This is an example of a situation described in the IRS June 12, 2014 notice to the effect that a specific tax year may have a portion of the liability that is subject to discharge and a portion that is excepted from discharge.

 

Example #1.8.

Facts. Assume all of the same facts as specified in Example #7, except that IRS never files a substitute return.

Result. As a result of the McCoy decision, in the Fifth Circuit, IRS is not legally obligated to write off any portion of the $120,000 tax debt. This is true because Taxpayer’s return was filed late, and under McCoy, a tax debt related to a late filed tax return can never be discharged in bankruptcy. However, because of IRS internal rules, IRS will voluntarily write off the entire $120,000 tax debt because IRS never filed a substitute return.

1.3. 240 Day Assessment Rule. A taxpayer can not discharge a tax in bankruptcy unless the tax authority assesses the tax more than 240 days before the taxpayer files for bankruptcy. If the taxpayer makes any offer in compromise, the 240 day time period is extended by the number of days the offer in compromise is pending, plus an additional 30 days. The 240 day rule normally comes into play only if the taxing authority audits a prior return and assesses additional tax as a result of the audit.        Index

Example #1.9. On April 15, 2011, Taxpayer files his 2010 tax return. On November 1, 2013, IRS commences an audit of the 2010 return. On April 16, 2014, as a result of the audit, IRS assesses $100,000 of additional tax. Taxpayer has satisfied both the 3 year age and 2 year filing rules, but the 240 day assessment rule will not be satisfied until after December 13, 2014; 240 days after IRS assessed the additional tax. To discharge the $100,000 of additional tax, Taxpayer can not file bankruptcy until on or after December 14, 2014.

1.4. Post Bankruptcy Tax Assessments. A taxpayer can not discharge a tax debt which is lawfully assessed after he files for bankruptcy. A taxing authority is legally permitted to start or continue a tax audit, and assess additional tax, after a taxpayer files for bankruptcy, if the time period for assessing additional tax has not already expired. This rule is intended to force a person to pay, and prevent discharge of additional taxes assessed after a bankruptcy filing.        Index

The general rule is that IRS has only three years from the return filing date to audit a return and assess additional tax. If the taxpayer has satisfied the 3 year age rule (a requirement for discharging the tax in bankruptcy), IRS can not legally assess any additional tax, with three important but rare exceptions. First, if the return omits gross income by more than 25 percent, IRS has 6 years from the return filing date to assess the additional tax. Second, IRS can assess additional tax at any time (forever) if the taxpayer files a fraudulent return or is guilty of tax evasion. Third, the tax assessment deadline can be extended if the taxpayer signs a written agreement extending the deadline. Therefore, the rule preventing a bankruptcy discharge of taxes assessed after the bankruptcy filing will rarely come into play, and will pose a problem only if: (1) IRS can prove that the taxpayer under reported income by more than 25 percent; (2) IRS can prove that the taxpayer is guilty of tax evasion or filed a fraudulent return; or (3) the taxpayer agrees to an extension of the assessment period.

Example #1.10.

Facts. Taxpayer files his 2008 federal income tax return on April 15, 2009. The return reports $100,000 of gross income and a $10,000 tax obligation. Taxpayer never pays any of the tax. He files for Chapter 7 bankruptcy on March 15, 2015, 5 years and 11 months after he filed the 2008 return. On April 14, 2015, IRS discovers that Taxpayer under reported $30,000 of gross income on his 2008 return. IRS immediately assesses $9,000 of additional income tax.

Result. IRS was legally authorized to assess the additional tax because: (1) post bankruptcy assessments are legally permitted; (2) gross income was under reported by more than 25 percent; and (3) less than 6 years elapsed between the return filing date and assessment of the additional tax. The bankruptcy filing will discharge the $10,000 of unpaid tax reported on the original return. However, the bankruptcy filing will not discharge the $9,000 assessment made on April 14, 2015 because the additional tax was legally assessable after Taxpayer filed for bankruptcy.        Index

1.5. Tax Fraud and Willful Evasion. A tax debt is not dischargeable if the taxpayer files a fraudulent return. A return is fraudulent if the taxpayer intentionally fails to report income or makes misrepresentations on the return. Likewise, a taxpayer can not discharge a tax in a Chapter 7 case if he willfully attempts to defeat or evade payment of the tax. The following conduct could qualify as tax evasion: (1) the taxpayer has the ability to pay the tax but uses the funds for other purposes; or (2) the taxpayer evidences a pattern of failing to file returns, failing to pay taxes, or attempting to hide income and assets. The tax fraud issue can be raised after the bankruptcy case is filed and closed.         Index

Example #11. Assume the same situation described in Example #1.10, except IRS does not discover the under reported income until April 15, 2010, 8 years after Taxpayer filed the tax return. If IRS can prove that Taxpayer filed a fraudulent return or was guilty of tax evasion, IRS can assess the additional tax at any time. The prior bankruptcy filing will not prevent IRS from assessing or collecting the additional tax.        Index