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Income Tax: Priority Debt in Bankruptcy?

The general rule for income taxes owed to federal, state, and local governments is that they will not be discharged in a Chapter 7 bankruptcy – you will owe them after your bankruptcy ends because they often are classified as priority debts. However, as with all generalizations, there are exceptions. We will look at both the general rule regarding priority debts as well as some exceptions. Also, the way that these taxes are handled in Chapter 13 bankruptcies will be mentioned briefly.

The first point to remember is that we aren’t looking at taxes for which a lien exists. For example, if the IRS files a federal tax lien against you for income taxes that you did not pay, there are no exceptions because this makes the tax debt into a secured debt that must be paid.

When there is no lien, any income taxes that you owe are unsecured debts. While the general rule with unsecured debts is that they are dischargeable in Chapter 7 bankruptcies, general rules – while not made to be broken – do bend at times under our laws. There are a number of unsecured debts that have been classified as priority unsecured debts. These must be paid prior to other claims, which is why they are termed “priority debts.” Although the nondischargeability makes them look like secured debts, this category of debts has no collateral protecting the creditor. However, their payment is considered more important than most unsecured debts, which is why this category exists.

Income tax debts – when not secured by liens – belong to this select group of unsecured debts given priority in bankruptcy. I had mentioned that income taxes generally are not discharged but need to explain when they are given priority. First, taxes on income for a year that ends no later than the date that you file your bankruptcy petition “for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition” are given priority. When these words from the Bankruptcy Code read very carefully, they basically mean that, if you fail to file a tax return that was due within three years before you filed for bankruptcy, you face a priority debt for any taxes that you owe for that tax return.

A second factor also can create a priority debt. The tax liability must have been assessed by the government within 240 days of your bankruptcy filing. When an “assessment” is made is defined by federal and state laws, but this date is when the amount of taxes that you owe has been determined by the government. In addition, if an offer in compromise existed or was pending during the 240 days, then the length of time that the offer existed is added to this period, along with an additional 30 days. In addition, there also are times when a bankruptcy previously filed during this time frame can extend the period for filing a new bankruptcy beyond the 240 days.

A third way that income tax debts can become priority unsecured claims is when you don’t file a tax return when it was due, which usually is April 15th of the following year for individuals. If the tax return was not filed, you cannot get the tax debt discharged in a Chapter 7 bankruptcy. You also can’t get the debt discharged if you failed to file the return when it was due and only filed it fewer than two years before filing for bankruptcy. In addition, if you filed a false return or simply attempted to evade paying your taxes, then you have created a priority debt. Income taxes that are assessable after a bankruptcy is filed will remain after the bankruptcy ends, as well.

As for interest and penalties on any income tax debts, you should expect these to be nondischargeable, too. On occasion, a tax penalty might be discharged if it is found to be punitive, which basically means that the penalty is so excessive to be a punishment instead of reflecting the cost of investigating and the loss based on what you did (or didn’t do), for example.

Although this is a somewhat simplified version regarding how income tax debt becomes a priority debt, some exceptions that will allow these debts to be discharged need to be noted. An income tax debt that is more than three years old with a return filed when it was due can be discharged. Another exception is when a return was filed late but was filed more than two years before the bankruptcy was filed – this debt may be dischargeable. In addition, any assessment of your tax liability by any of the taxing authorities (federal, state, or local) that occurred more than 240 days before you filed for bankruptcy can lead to a discharge of the tax debt. As mentioned earlier, older income tax debts are much less likely to be classified as priority debts.

Income tax debt also has implications in Chapter 13 bankruptcies. To summarize Chapter 13’s treatment of income tax debts, a lien again creates a secured debt, and this must be paid. Without the lien, an income tax debt can become a priority debt when it falls within the criteria outlined for a Chapter 7 filing. Although interest could be dischargeable, it is likely to remain when the tax debt has priority status. Likewise, penalties on these debts are nondischargeable to the same extent as they would be with Chapter 7. Therefore, your Chapter 13 plan would have to account for making payment of these debts.

Finally, it should be remembered that, when only one spouse owes the tax debt, a married couple’s property owned by the entireties is protected in a bankruptcy. In addition, this applies to the property of a spouse who does not owe taxes and is not part of the bankruptcy filing. And there is a last word of caution that anyone with income tax debts needs to remember: you can’t get around the priority nature of income tax debts by paying them with credit cards or other types of debt instruments – your new debt will be nondischargeable, even though your tax debt is gone.

As this brief look at priority debts that involve income taxes owed to federal, state, or municipal governments illustrates, this can be a difficult area of the law to navigate successfully. Of course, the same can be said of bankruptcy in general. This is why, if you are thinking of filing for bankruptcy, you also should think of discussing the possibility with someone who has experience helping individuals through this process. You do not want to get yourself into a situation that might do you more harm than good in the end.