Bankruptcy is often the best method of resolving unpaid tax debts. The U.S. Tax Court recently addressed one of the rules for discharging unpaid tax debts in bankruptcy in Lehman v. Commissioner, T.C. Summary Opinion 2008-83.

Facts & Procedural History On Lehman’s Case

In Lehman, the taxpayers initially sought Chapter 13 bankruptcy relief. The taxpayers filed their tax returns as part of this process. Three and one half years after the taxpayers filed Chapter 13 bankruptcy, the bankruptcy court confirmed the taxpayers’ plan of reorganization.

The taxpayers were ordered to pay their unpaid tax debt liabilities over a 33 month period. Shortly thereafter the taxpayers moved to dismiss their Chapter 13 petition. The bankruptcy court eventually approved the dismissal, which resulted in the taxpayers’ tax liabilities not being discharged.

The taxpayers then filed a Chapter 7 bankruptcy petition. Three months later, which was 5 years after the taxpayers submitted their Chapter 13 bankruptcy petition, the bankruptcy court discharged the taxpayers’ debts.

The IRS then issued the taxpayers a Notice of Intent to Levy for three of the older tax periods. The taxpayers appealed the Notice, believing that these tax liabilities were discharged in bankruptcy. The IRS held its ground and Tax Court litigation ensued.

As the U.S. Tax Court pointed out, the taxpayers failed to realize the impact that their Chapter 13 filing had on the discharge of their unpaid tax liabilities. Generally, unpaid tax debts may be discharged in Chapter 7 bankruptcy if the tax return was due to be filed more than 3 years prior to the date the Chapter 7 bankruptcy petition was filed. This three year period is often referred to as the three year look-back period.

The idea is that taxpayers should be able to discharge these older tax liabilities in bankruptcy, but not newer tax liabilities.  Thus, if the tax return was due to be filed during the 3 year look-back period, the unpaid tax debt for that year is not dischargeable in bankruptcy.

If the taxpayer acts to hold open the 3 year look-back period, the 3 year look-back period will be extended for the period of time that the taxpayer holds it open. There are a number of ways that this period of time can be held open.  Filing a bankruptcy petition is one such way.  This is what the taxpayer’s Chapter 13 filing did. Because of the taxpayer’s Chapter 13 filing, the 3 year look-back period for the taxpayers’ Chapter 7 filing was extended to seven and a half years. Because the tax debts for the older tax years were due to be filed during this period of time, the unpaid tax debts for these years were not dischargeable in bankruptcy.

Had these taxpayers consulted with a tax attorney, they may have been able to time their bankruptcy filings and discharge their tax debts in bankruptcy.

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