When the governmet confers a benefit, it invariably puts conditions on the benefit.
Congress will often modify the conditions over time. The result can be a very nuanced set of rules that, to the uninitiated, can seem nonsensical and impossible to descipher.
The rules that allow taxes to be discharged in bankruptcy fall into this category. The recent Kun v. Internal Revenue Service, No. 22-cv-04641-RS (N.D. Calif. 2022), case provides an example to look at one of these rules–namely the three year and 240 day rule.
Facts & Procedural History
This case involves a taxpayer who filed a Chapter 11 bankruptcy in November 2015. The Chapter 11 bankruptcy was converted to Chapter 7.
In August of 2021, the IRS sent the taxpayer a notice for taxes due for the 2012 and 2013 tax years.
The taxpayer re-opened his bankruptcy case and sought a declaratory judgment that the taxes had been discharged by the Chapter 7 bankruptcy.
The IRS filed a motion to dismiss, which was granted by the Bankruptcy Court. This appeal followed.
About Discharging Taxes in Bankruptcy
Taxes can be discharged in bankruptcy, but there are several rules that have to be met.
The rules are found in 11 U.S.C. § 507(a)(8). This Code section sets out the priority of when claims are paid. Claims with higher priority get paid first.
Subsection (a)(8) is for unsecured claims by the government for taxes. Subsection (a)(8)(A) addresses income taxes:
a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition—
(i) for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;
(ii) assessed within 240 days before the date of the filing of the petition, exclusive of—
(I) any time during which an offer in compromise with respect to that tax was pending or in effect during that 240-day period, plus 30 days; and
(II) any time during which a stay of proceedings against collections was in effect in a prior case under this title during that 240-day period, plus 90 days; or
(iii) other than a tax of a kind specified in section 523(a)(1)(B) or 523(a)(1)(C) of this title, not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case;
You can see from (i) that there is a three-year timing rule and from (ii) that there is a 240-day timing rule.
The (i) and (ii) rules are connected by an “or,” so if either rule applies, the taxes are not dischargeable.
In the present case, the taxpayer did not satisfy the three-year rule. As noted by the court:
Appellant concedes his 2012 income taxes were due on April 15, 2013, and his 2013 income taxes were due on April 15, 2014. See Appellant Brief, at 14. These both satisfy the three-year rule: three years before the date of Appellant’s initial bankruptcy filing would be November 5, 2012, and both obligations were due after this date.
The 240-day rule did not have to be met as the three-year rule was met. Thus, the appeals court had little difficulty in affirming the Bankruptcy Court’s opinion.
Working With IRS Collections
While the taxpayer did not prevail in this case, the case does show how to remedy when the IRS tries to collect taxes that are discharged in bankruptcy.
The process is to ask the Bankruptcy Court permission to re-open the bankruptcy case and then seek a declaratory judgment that the taxes were discharged in the bankruptcy.
This is often the only viable way to resolve these types of cases as the IRS will often not make the adjustment administratively. Even an offer in compromise based on doubt as to liability will fail as, in our experience, the IRS will not make the adjustment using its settlement powers.
If the taxpayer is not doing well financially, they may be able to qualify for an offer in compromise based on doubt as to collectibility. This again would turn on their financial situation. One would presume that, in most cases, the taxpayer would be in decedent financial shape having just had their debts discharged in bankruptcy. This can make getting an offer in compromise approved very difficult.