Tax debts in bankruptcy are a weighty and serious topic. Statistics show that in 2019, over 770,000 individuals filed for bankruptcy in the United States, and approximately one-third of those involved some type of tax debt. This highlights the common struggle individuals face in paying their tax obligations.
Bankruptcy is a common method for resolving unpaid tax debts for those facing financial burdens. However, discharging tax debts in bankruptcy requires meeting specific eligibility requirements, including the three-year lookback rule.
In the recent case of Lehman v. Commissioner, T.C. Summary Opinion 2008-83, we have an opportunity to consider how the three-year lookback period rule dictates whether tax debts can be discharged in bankruptcy.
Facts & Procedural History
The taxpayers in Lehman 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 debts 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.
About Bankruptcy and Discharging Taxes in Bankruptcy
The bankruptcy process typically starts with the filing of a bankruptcy petition. In order to file for bankruptcy, an individual must complete and file a petition with the bankruptcy court that has jurisdiction over their case. The petition must include detailed information about the individual’s assets, debts, income, expenses, and other financial information.
After the petition is filed, an automatic stay goes into effect, which temporarily halts collection efforts by the IRS or state taxing authorities. This provides the taxpayer with some breathing room to assess their options for dealing with their tax debts.
Non-dischargeable tax debts are tax liabilities that cannot be eliminated through bankruptcy. Payroll tax debt, which consists of taxes withheld from employees’ paychecks, and fraud penalties, such as those imposed on taxpayers who intentionally underreport income or commit tax evasion, are examples of non-dischargeable tax debts. In some cases, federal, state, and local taxes may be eligible for discharge in bankruptcy if they are several years old. This means that the tax debt may be eliminated through the bankruptcy process, providing relief to the debtor.
Income tax debt is typically difficult to discharge in both Chapter 7 and Chapter 13 bankruptcy. However, under specific circumstances, income tax debt may be discharged in Chapter 7 bankruptcy, which involves the liquidation of the debtor’s assets to pay off their debts. In a Chapter 7 bankruptcy, tax debts are usually prioritized and paid first when the debtor’s assets are liquidated.
In order to discharge tax debts in bankruptcy, the taxpayer must meet certain eligibility requirements. The three-year lookback rule is a crucial factor in determining whether or not a tax debt is eligible for discharge in bankruptcy.
The Three-Year Lookback Rule
The three-year lookback rule is an important aspect to consider when filing for bankruptcy to discharge tax debts.
This rule states that only tax debts that are at least three years old can be discharged in bankruptcy, and the due date of the tax return associated with the debt must have been at least three years prior to filing for bankruptcy. This means that if a tax return was due to be filed during the three-year look-back period, the unpaid tax debt for that year is not dischargeable in bankruptcy.
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 three-year look-back period, the unpaid tax debt for that year is not dischargeable in bankruptcy.
To illustrate how the discharge provisions for tax debts work in practice, let’s consider some examples:
Example 1: John owes $10,000 in federal income taxes from 2017. He filed his tax return on time and the taxes were due on April 15, 2018. John files for Chapter 7 bankruptcy on June 1, 2021. Since the three-year waiting period starts from the due date of the taxes (April 15, 2018), John’s tax debt is eligible for discharge in bankruptcy.
Example 2: Mary owes $5,000 in federal income taxes from 2016. She filed her tax return late and paid the taxes owed in full on October 1, 2017. Mary files for Chapter 7 bankruptcy on June 1, 2021. In this case, the three-year waiting period starts on October 1, 2017 (the date Mary actually paid her taxes). Therefore, Mary’s tax debt is not eligible for discharge in bankruptcy.
Extending the Three-Year Lookback Period
There are some exceptions to this three-year look-back rule. If the taxpayer acts to hold open the three-year look-back period, the three-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.
For example, if a tax return was filed late, the three-year waiting period starts from the date the return was actually filed. In addition, if a taxpayer entered into an offer in compromise with the IRS or had a previous bankruptcy case dismissed within certain time frames, these events can affect whether or not a tax debt can be discharged.
As the U.S. Tax Court pointed out, the filing of a Chapter 13 bankruptcy has a similar effect. This is what the taxpayer’s Chapter 13 filing did. Because of the taxpayer’s Chapter 13 filing, the three-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.
While filing for bankruptcy may not be the first option for individuals struggling with tax debts, it can provide a fresh start and relief from overwhelming financial burdens. It is important to consult with a tax attorney and understand the various rules and exceptions surrounding tax debt discharge in bankruptcy in order to make an informed decision. The three-year lookback rule is a crucial factor to consider when filing for bankruptcy to discharge tax debts. By understanding this rule and other eligibility requirements, individuals can take advantage of the bankruptcy process and discharge their tax debts, allowing them to start anew with a clean slate.