This is the fourth post in the Collection Options series. This series is dedicated to presenting individuals and businesses with options for dealing with outstanding tax obligations.

Bankruptcy. We encourage anyone interested in filing a petition for relief in bankruptcy to meet with a skilled bankruptcy attorney to evaluate their situation and options. This post is designed to help a taxpayer understand some of the issues involved in discharging tax obligations and help prepare them for a meeting with the bankruptcy attorney.

Chapter 7 Bankruptcy. Income taxes (not trust-fund or withholding taxes) are dischargeable in a Chapter 7 Bankruptcy if certain conditions are met. To start, you should examine the following elements to determine if bankruptcy is an option:

Three Years. Has it been more than three years since the original due date, including extensions, for the Return? If not, the taxes are not dischargeable.

Two Years. If the Tax Return was filed after the original due date, has it been more than two years since the late Return was filed? If not, the taxes are not dischargeable.

240 Days. Has it been more than 240 days since the taxes were assessed? If not, the taxes are not dischargeable.

Fraud/ Misrepresentation. Are the tax obligations due to the taxpayer’s fraud or misrepresentation. If so, that may render the taxes not dischargeable in a Chapter 7. Interestingly, the fraud penalty itself may still be dischargeable.

Service Filed Returns. Is the tax obligation the result of the Internal Revenue Service filing returns for the taxpayer because the taxpayer failed to file? If so, the taxes may not be dischargeable.

Liens. While liens don’t effect the dischargeability of the tax, the lien may survive the bankruptcy thereby making the discharge practically ineffective. If the taxpayer files the bankruptcy prior to the Internal Revenue Service filing Tax Liens, then the taxpayer will have the opportunity to completely avoid the tax claims. However, if the Internal Revenue Service filed Tax Liens against the taxpayer prior to filing bankruptcy, the bankruptcy may discharge the debt, but those Tax Liens may continue to encumber the taxpayer’s property. For example, if the IRS Tax Lien encumbered the taxpayer’s homestead which had $20,000.00 of equity, the Internal Revenue Service’s underlying tax may be discharged, but the Internal Revenue Service would still have a lien against the home for the equity that the taxpayer had at the time he filed bankruptcy. If the taxpayer has no equity in any assets, then the lien loses its importance but must still be removed from the county and state records after the bankruptcy. This can be accomplished with an Application for Release of Federal Tax Lien.

Chapter 13 Bankruptcy. A Chapter 13 Bankruptcy is not designed to discharge all debts completely. Instead, it is a way to force the taxpayer’s creditors into a long-term installment arrangement (for example, five years). A Chapter 13 bankruptcy may be appropriate for taxpayers who do not want to file a Chapter 7 bankruptcy, or whose taxes would not be entirely discharged in a Chapter 7 bankruptcy. Often, a portion of the taxpayer’s tax obligation can be discharged under a Chapter 13 bankruptcy and the balance of nondischargeable taxes can be paid over time.

The bankruptcy laws were created, in part, to give a fresh start to individuals struggling through a difficult financial situation. This includes relieving taxpayers of the overwhelming burden of old tax, penalty, and interest obligations. Taxpayers who are looking at their options for resolving their outstanding tax obligations, like an Installment Agreement or an Offer in Compromise, should consider bankruptcy and talk with an experienced bankruptcy attorney. It will not be appropriate for all situations, but for some, it will clearly be the best choice. This article is intended to give you some background to begin your analysis.

Whether income taxes can be eliminated through a bankruptcy is primarily an issue of the age of the tax obligation. Income taxes are dischargeable in bankruptcy if the petition in bankruptcy is filed more than three years after the due date for the return, more than two years after the date the return was filed, and more than 240 days after the taxes were assessed. There are additional considerations, but this is the starting point.

The Due Date. The due date of the return is either April 15 or, if the taxpayer filed a request for an extension of time to file, the extension date. Prior to January 1, 2006, the filing date could be extended to August 15 or October 15. For extensions requested after December 31, 2005, the extension date is automatically October 15. For example, the due date for a 2005 Form 1040, where a request for an extension was filed on or before April 15, 2006, will be October 15, 2006. Taxes from this 2005 Form 1040 will satisfy the “three year” test for dischargeability after October 15, 2009, that being three years after the due date.

The Filing Date. The filing date is a key element in those situations when a taxpayer files his or her returns after the due date. For example, three years after the due date for a 2001 Form 1040 may be long gone, but if the return was not filed until December 1, 2008, the obligation will not be dischargeable until December 2, 2010, more than two years after the date the return was filed.

You should take special notice that this test requires the return to be the taxpayer’s return, not an IRS Substitute For Return (SFR) under IRC Section 6020(b). If the taxpayer does not file his or her own return, the IRS may prepare an SFR. The taxes owing on the SFR are usually higher than the amount the taxpayer really owes. To correct this, the taxpayer must file amended returns. If the amended return does not make a significant change from the SFR, and it appears it was filed only to start the running of the two year period for dischargeability, the IRS and the Bankruptcy Court may reject the return and treat the SFR as the original and only return. This would make the obligation non dischargeable. An example of this is a single wage earner who has no other income and no deductions other than personal exemptions and the standard deduction. The SFR will usually be fairly accurate and the taxpayer’s amended return will be perceived as nothing more than an attempt to make the taxes dischargeable, not an honest and genuine effort to comply with the tax laws. This taxpayer will be stuck with the SFR and unable to discharge the obligations in bankruptcy.

The Assessment Date. The law gives the IRS 240 days from the date the taxes were assessed to file a lien to protect its interests before the taxpayer files a bankruptcy. By filing a lien, the IRS will protect itself to the extent its lien attaches to equity in the taxpayer’s assets.The taxpayer must be careful not to inadvertently give the IRS more than this 240 days. If a taxpayer files an Offer in Compromise within this 240 days, the running of the 240 days stops until the offer is withdrawn or rejected, plus 30 days. For example, on the 239^th day after the assessment of taxes from an audit, the taxpayer files an Offer in Compromise and that Offer is finally rejected or withdrawn one year later. The taxpayer was one day away from having dischargeable taxes and now, one year later, he must wait an additional 31 days.

Federal Tax Lien. While the bankruptcy can discharge the income taxes, it does not eliminate the federal tax lien. For example, if the taxpayer has equity in real estate and the lien is properly filed to encumber that real estate, the lien will survive the bankruptcy. Thus, if a taxpayer owes $100,000 in dischargeable taxes, but he or she also owns equity in real estate of $200,000, and the IRS has a properly filed priority lien, the bankruptcy may stop the IRS from levying wages and bank accounts, but it will do very little to relieve the taxpayer of the liability. After the bankruptcy, the IRS will try to collect the taxes from the equity in the real estate.Before a taxpayer starts negotiations with the IRS for an installment agreement or an Offer in Compromise, he or she should contact an attorney to review bankruptcy as an option. Bankruptcy will not be appropriate for everyone, but for some it may be the best way to start fresh and build a new life.