Can Bankruptcy Clear IRS Debt?

Several months after one of the biggest tax code rewrites in U.S. history, the Treasury Department finally released an online tool to help taxpayers re-calculate their withholding amounts. Nevertheless, millions will owe money come tax time.

Earlier, the IRS did release revised tax tables that conveyed the same information. But information formats like that are difficult for people to understand. The proper withholding amount is very important, emphasized American Institute of Certified Public Accountants chief tax analyst Melissa Labant. Too little, and the taxpayer will owe a significant amount in April. Too much, and “you’re giving an interest-free loan to the government.” Cari Weston, another AICPA tax analyst, added that the more allowances a taxpayer claims, the less money the government withholds.

Further complicating the issue, almost 10 percent of Minneapolis workers moonlight at a second job. At a minimum, the additional W-2 income disrupts withholding calculations. But a number of these people moonlight as freelancers or as independent contractors. There is no employer to withhold taxes, and many of these individuals fall behind on their quarterly estimated tax payments.

Most people have had unpleasant interactions with private debt collectors. But the law sharply limits their power. The IRS is largely immune from these laws. For example, the IRS has ten years to collect past-due income tax debt. In Minnesota, the statute of limitations on credit card and other debt is usually four years. Additionally, the government has many more collections tools than private debt-buyers. That includes things like wage garnishment and bank account levies.

Bankruptcy Stops Adverse Action

The U.S. Code is quite clear that the automatic stay applies to the IRS. So, bankruptcy is one of the only things that can stop IRS harassment. Typically, the automatic stay prevents such action for as long as the case is pending. Even if the underlying debt is not dischargeable, the IRS or other bill collector can do nothing about it until the case is over.

In rare cases, the bankruptcy judge does give moneylenders, including the IRS, permission to get around the stay. Also, the stay does not apply to post-petition debt.

Bankruptcy Discharges Old Income Tax Debt

In many cases, consumer bankruptcy eliminates tax debt. As one might expect, there are a number of rules. First, the general requirements. The debt must be income tax debt. Property taxes, business trust taxes, and any other taxes are usually not dischargeable under any circumstances. Second, there must be no fraud or willful tax evasion. The standard or proof is about the same in Bankruptcy Court as it is in Tax Court. So, to establish fraud, the IRS needs substantial evidence.

Now, for the specific rules. The IRS is a very meticulous, numbers-based agency. If the taxpayer files even a few days too early, the IRS usually bitterly contests discharge.

• Three Years: The income tax debt must be at least three years old. This rule is not as simple as it seems. Bear in mind that Tax Day is not always April 15. Also, if the IRS grants an extension, that move changes the due date.
• Two Years: The returns must have been on file for at least two years prior to the petition date. This rule is a little more straightforward. However, bear in mind that the substitute returns which the Service files on your behalf do not count.
• 240 Days: The technical rule is that the IRS cannot have “assessed” the debt within the last 240 days. This process is rather difficult to define. Generally, if you have not received a letter or notice within the last eight months, you probably pass the 240-day test.

State income taxes from the Minnesota Department of Revenue, or any other state agency, are also dischargeable under the 3-2-240 criteria.

Bankruptcy eliminates the legal obligation to repay the debt but not the debt itself. So, bankruptcy does not eliminate tax liens. Lien removal is a separate process that’s beyond the power of a bankruptcy judge.

Some Non-Bankruptcy Alternatives

Kain & Scott is a debt relief organization. Usually, bankruptcy is the best tool to eliminate debt. But that’s not always the case. With regard to delinquent taxes, there may be a few non-bankruptcy alternatives to consider:

• Offer in Compromise: If you qualify, the IRS accepts part of the delinquent amount and writes off the remainder. Those TV commercials which claim to settle IRS debt “for pennies on the dollar” are the extreme results of an OIC.
• Installment Agreement: There are several different kinds of agreements for individuals, or businesses, that owe less than $100,000. In some cases, the IRS may take part of the amount and forgive the rest.
• Innocent Spouse: Spouses who signed fraudulent tax returns without knowing all the facts may be able to eliminate their tax debt. Sometimes, innocent spouse cases are rather hard to prove in Tax Court.

The Minnesota DOR offers similar programs to help people retire delinquent state tax debt. Many of these matters are quite complex. So, we often refer our clients to well-qualified and experienced tax attorneys.

Bankruptcy often provides immediate and long-term protection from the IRS and other taxing authorities. For a free consultation with an experienced bankruptcy attorney in Minneapolis, contact Kain & Scott. We have nine office locations throughout Minnesota.