Contrary to popular opinion, most taxes can be discharged (i.e., wiped out) in bankruptcy. The general rule in bankruptcy is that ALL debts are discharged. That is, for a debt to survive the bankruptcy, there must be a specific exception to the general rule.

SOME BACKGROUND

Bankruptcy is a legal proceeding in federal court governed by federal law and principles of equity ( i.e. fairness.) The purpose of bankruptcy is to give debtors a "fresh start". The filing of a bankruptcy petition usually results in the discharge of certain unsecured debts and/or the debtor is given the opportunity to pay his debts in installments.

The filing of a bankruptcy petition operates as a "stay" which stops the debtor’s creditors (also including the IRS) from pursuing any collection activities against the debtor without permission of the bankruptcy court.

There are four operating chapters in bankruptcy, 7, 11, 12 and 13. In each there is a court appointed trustee (usually a local lawyer) who plays an important role.

Chapter 7 is the most common operating chapter. Chapter 7 is straight liquidation bankruptcy. The debtor’s nonexempt assets (e.g., everything other than homestead, IRA’s, etc.) on the date of filing the bankruptcy petition become assets of a bankruptcy "estate" which is administered by the trustee. The trustee converts the estate assets to cash and distributes the cash among the creditors in accordance with certain priority rules. It’s a "snapshot event" in the sense that, generally speaking, the debtor’s assets and liabilities are determined as of the petition date. (Three important exceptions relate to rights to an inheritance, life insurance proceeds or a divorce property settlement arising within 180 days after the petition date.) The debtor’s post-petition earnings belong to the debtor.

It rarely matters, but the bankruptcy estate of an individual in chapter 7 (or chapter 11) is a separate taxable entity, which means the estate files its own tax returns. The debtor has the right to make an election to divide his taxable year into two short taxable years, one before and one after the petition. If the election is made, the debtors liability for the first short taxable year is a priority debt (see below) in the bankruptcy case.

Under the new Bankruptcy Act, if you have mostly consumer debt or if you make above average income the court can force you into a chapter 13 or dismiss your chapter 7.

Corporations do not get a discharge in chapter 7.

Chapter 11 (a.k.a. "Reorganization") is used by large corporations to restructure their debts. Sole proprietors and other small businesses are also eligible to file chapter 11, but chapter 11 is procedurally complex and expensive. The debtor is usually named as trustee in chapter 11 cases and the business continues to operate.

In chapter 11 a plan is approved by the court (sometimes after considerable litigation) which thereafter governs the relationship of the debtor with its various creditors. Generally speaking, the plan must be approved by the creditors, although in some situations the plan can be "crammed down" creditors’ throats. Regarding taxes, an important requirement for plan approval is that each of the debtor’s priority taxes (see below) be paid within certain time limits.

Chapter 12 is basically chapter 13 with liberalized rules for farmers.

Chapter 13 is for individuals with regular income. To be eligible, the debtor’s unsecured debts may not exceed $250,000 and total debts may not exceed $1,000,000 (adjusted for inflation).

There is no bankruptcy estate in a chapter 13. Instead, the debtor keeps his assets and post-petition income and files a plan with the court calling for monthly payments to be made to the trustee, who then distributes the payments among the creditors in accordance with the terms of the plan. The monthly installment under the plan is usually equal to the difference between the debtor’s estimated income and necessary living expenses over the following five years.  In some cases the debtor can control the size of the monthly payments via his estimates of income and expenses.

If certain tests are met (two of which are of immediate significance) and all of the payments are made, all of the debtor’s unsecured debts are discharged on culmination of the chapter 13 plan. One of the tests is that each creditor gets more than the creditor would have received if the debtor had filed a chapter 7. The other is that the debtor’s "priority taxes" must be paid under the terms of the plan. The same dollars can be used to meet both tests. In a sense, this often means the debtor pays his priority tax debts by buying back his assets.

PRIORITY TAXES

"Priority taxes" are never discharged in bankruptcy. The subject can get complex, but the shorthand rules of thumb are that trust fund taxes (regardless of age) and recent income taxes are priority taxes.

Trust fund taxes are taxes collected by the debtor and not paid over to the government, such as employee withholding and sales taxes. (The trust fund penalty imposed on responsible individuals for a corporate failure to pay over taxes withheld from employees is also considered a priority tax.)

"Recent" income taxes for such purposes are those where

(i) the due date of the income tax return, including extensions, is less than three years prior to the date the bankruptcy petition was filed,

(ii) the taxes were assessed within 240 days of the petition filing date (plus any time that an offer in compromise was pending plus 30 days), or

(iii) the tax is not yet assessed, but assessable (i.e., the IRS can still audit) at the time the petition is filed. 

Interest on priority taxes is treated like the underlying tax. Penalties are similarly treated, but the rules are more favorable.