Filing timely tax returns is key if you wish to discharge tax debt in bankruptcy
It is possible to discharge income tax debt in bankruptcy, however, not all taxes are eligible and timing plays a very important role. If you’re anticipating tax troubles on the horizon, it is always best to go ahead and file a tax return. Failure to do so can result in the IRS preparing a “Substitute for Return” and wildly overestimating your tax bill. If the Substitute for Return becomes final and the taxes are formally assessed, you just lost your ability to discharge your tax debts in bankruptcy. Section 523 of the bankruptcy code provides as follows:
(a) A discharge under section 727 . . . of this title does not discharge an individual debtor from any debt —(1) for a tax or a customs duty — . . .(B) with respect to which a return, or equivalent report or notice, if required —(i) was not filed or given. . . .
This provision serves as a warning to debtors: failure to file a tax return will not only cause you to incur penalties and fees, it can jeopardize your rights in bankruptcy.
In Re Smythe
A recent decision out of the United States Bankruptcy Court in Tacoma, Washington, In Re Smythe, holds that debtors who fail to file a tax return before the IRS issues an assessment have just lost their ability to discharge assessed taxes in bankruptcy. The facts of the Smythe case are fairly straightforward: the Smythes filed for chapter 7 bankruptcy seeking to discharge income tax debts for 1999-2004. The IRS conceded that the 03′ and 04’taxes could be eliminated, but argued that the taxes for 99′-02 were non-dischargeable because assessments were made before the debtors filed 1040s. The IRS argued that it was their assessment, not the subsequent filing of the 1040, that created the tax debt. The IRS assessed debt was one in which no return was filed or given, therefore the debts were non-dischargeable under section 523. The Court agreed with the IRS argument:
Given the plain language reading of “debt” in the Bankruptcy Code and the holding inWogoman, the Court agrees with the I.R.S.’s argument. When the I.R.S. made tax assessments against the Debtors, the Debtors’ tax obligations became enforceable and the I.R.S. could pursue its claims; therefore, the assessments created “debt[s]” as defined in the Bankruptcy Code. Although the Debtors subsequently filed Forms 1040, the tax debts had already been established by the I.R.S. assessments. The tax debts, therefore, are debts “for which no return was filed,” and are nondischargeable under § 523(a)(1)(B)(i)
The Bottom Line
Even if you can afford to pay your tax bill, failing to file a tax return is not a good idea. In addition to the penalties that the IRS charges for late payment, they also charge additional penalties for late filing. Not to mention the fact that technically, failing to file a tax return is a crime. there isn’t a worse creditor to own money to them the government, letting tax problems faster can not only increase penalties but jeopardize your ability to shed these debts through bankruptcy.