It’s quite common for New York bankruptcy debtors to owe tax debts, and because tax season is here, I think now is a worthwhile time to advise debtors who might believe they are unable to pay their tax bills why it’s important to at least file an income-tax return come April 17th. (April 15th is a Sunday, and April 16th is a holiday in Washington D.C. only, so the IRS will be closed.)
Reason number one is that the IRS penalizes debtors who don’t file their returns, even if they don’t pay in full. The penalty is 5 percent of the amount one ultimately owes, and this percent increases by 5 percent for each month the return isn’t filed, up to 25 percent. That’s a hefty penalty. On top of even that, the IRS will charge interest with no limit. This is how tax debts can go severely out of control.
Reason number two: Unpaid tax debts are dischargeable in bankruptcy but only if debtors meet specific criteria established by the Bankruptcy Code. They are the three-year rule, the two-year rule, and the 240-day rule. Here they are:
Three-year rule: The taxes must be due no fewer than three years before the bankruptcy filing plus extensions.
Two-year rule: The debtor must have filed a tax return including the tax debt no fewer than two years before the bankruptcy petition.
240-day rule: The tax debt must have been assessed, if ever, at least 240 days before the bankruptcy. Usually this occurs promptly after the return is filed, but if the IRS audits the debtor subsequently or disputes the tax return, then the clock for this rule is reset.
Of relevance here is the two-year rule. By filing a timely tax return, debtors start the two-year clock as early as possible. Moreover, I once listed these criteria in a post titled, “bankruptcy courts are becoming less forgiving of late tax returns,” but it also discusses a split among bankruptcy courts over whether a late return satisfies two-year rule’s filing requirement. Although the issue has not arisen in the Second Circuit, some courts have barred the dischargeability of tax debts simply because some of the returns were filed after the deadline.
Filing sooner rather than later also starts the clock on the statute of limitations for tax-debt collections by the federal government. If the government doesn’t attempt to collect the tax debt by that time, it must cease its collection efforts.
Reason number three: The return for last year’s taxes set debtors’ withholdings and estimated tax payments for this year. Obviously, debtors who over-withheld last year won’t need to worry about being unable to pay tax bills this year because they will be due refunds, but debtors who have under-withheld will owe a larger amount of money than if they’d set their withholding properly. Indeed, under-withholding may be a reason why some debtors don’t have the money around to pay the IRS: They didn’t budget properly and can’t afford a large bill. Setting withholding to a proper level will ensure that taxes are paid on a timely basis.
The return for last year’s taxes also helps debtors calculate the amount they will owe for their quarterly estimated tax payments. If debtors underpay their estimated taxes, then they might incur penalties. The same tax penalties can also occur because of under-withholding.
Reason number four is that the IRS offers debtors extension plans and repayment options. Even if debtors pay a little money with their returns, they can still use extensions to stay on track.
If you owe significant tax debts then it’s possible to settle them with the IRS as an alternative to bankruptcy. If that will not work, then it may be possible to discharge them in a chapter 7 case or repay them over five years in chapter 13 without interest while discharging older taxes under certain circumstances. To discuss these options, talk to an experienced New York bankruptcy lawyer.
For answers to more questions about tax debts, bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced Brooklyn bankruptcy attorney Bruce Weiner for a free initial consultation.