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Caution: not all taxes are discharged in bankruptcy.

The 1990s have seen a substantial increase in the number of individual bankruptcy proceedings. These victims of the recession have included "successful" businesses forced to seek the protection of the Federal courts to reorganize or completely liquidate. The practitioner has discovered his or her client is not immune to bankruptcy. In many cases, the client will turn to the tax practitioner for advice and referral. Most practitioners know little about the bankruptcy laws. Often the practitioner is sympathetic; however, after the referral, the practitioner washes his or her hands of the case. The practitioner should understand he or she possesses facts and knowledge that may help the taxpayer and the bankruptcy adviser with the tax aspects of the client's bankruptcy.

The focus of this article concerns the individual taxpayer entering bankruptcy. One of the most common misconceptions is that a bankruptcy action will discharge all taxes owed by the client. This is false, and practitioners that advise clients and bankruptcy lawyers must be aware of the circumstances in which taxes are not discharged.

The most common income tax situations that are not discharged in bankruptcy are the following: 1. Three-Year Rule: Income taxes

related to an income tax return

which was due within three years

of the date of the bankruptcy


Example: A 1989 income tax

return filed on April 15, 1990,

could not be discharged if the

petition was filed before April

15, 1993. 2. Fraudulent Returns: Income

taxes related to a fraudulent return

if the Service has assessed a

fraud penalty.(2) 3. Late-Filed Returns: In the case

of a delinquent unfiled return for

a tax year or years earlier than the

three preceding years, there will

be no discharge if the tax assessed

with respect to the return

was assessed within 240 days

before the date of filing a petition

in bankruptcy.(3)

Example: A taxpayer failed to file

his 1984 tax return which was

due on April 15, 1985. On

January 1, 1992, he files the

return. The tax is assessed by the

Service Center on February 1,

1992. The taxpayer could not

discharge the income tax liability

if he/she filed a petition in

bankruptcy within 240 days of

February 1, 1992.

Most practitioners are aware of the three circumstances prohibiting discharge discussed above. The following circumstances are less known and have caused substantial difficulty for clients who thought bankruptcy had given them a fresh start.

Trust Fund Penalty Cases (Section

6672) and Employment Tax

Cases (Section 3402)

One of the most stringent penalties that can be assessed is the responsible person penalty assessment under Section 6672 of the Code.(4) When a corporation fails to payover withheld taxes and FICA collections and lacks the assets to pay the assessment, the IRS looks to a person or persons they designate as the person(s) responsible for the trust fund portion of the employment taxes. The amount assessed is both the withheld income taxes and the FICA taxes that should have been collected from the corporation's employees and forwarded to the Treasury. The IRS can collect this amount in the form of a penalty against the responsible person.

In the case of a failed small business this is, but is not limited to, the president and principal shareholder(s) of the defunct corporation. The key is that the assessed amount is not a tax, it is a penalty. Section 523 of the bankruptcy code specifically excludes from discharge tax penalties.(5) In the case of a sole proprietor or a partnership, withheld taxes are a priority item under the bankruptcy code and are therefore not dischargeable.(6)

Unfiled Returns

Taxes that are assessed with respect to unfiled income tax returns are not discharged.(7) Unfiled returns include all cases wherein the taxpayer has not filed a return. In addition, the rule also applies in the following situations.

6020 Returns: Section 6020 of the Internal Revenue Code permits the Service to prepare and file a substitute return for a taxpayer who has not filed a return. Procedurally, the Service Center will prepare the return based upon third-party information items such as W-2s and 1099s. The Service Center then mails the substituted return to the taxpayer. The taxpayer has 30 days to sign and return the substitute return or prepare his own return. If the taxpayer does neither, the Service will assess the tax contained on the substitute return. In two recent cases, the courts have held that unsigned 6020 returns are not returns for purposes of bankruptcy discharge. In the eyes of the bankruptcy court, it is deemed that no return has been filed. Therefore, the taxes associated with the return are not discharged in bankruptcy.(8)

Practitioners advising bankruptcy professionals and/or clients must determine if all returns have been filed. If a 6020 return has been filed by the Service, it must be determined if the taxpayer has signed the 6020 return. If he/she has signed and returned the substitute return, it becomes his/her return.(9) In the absence of proof that the taxpayer has filed and signed a return, the client, prior to seeking the protection of a bankruptcy court discharge, must file the return and wait 240 days after the posting of the assessment of the tax by the Service Center prior to filing a petition in bankruptcy.

Offers In Compromise: Often as a prelude or as an option to bankruptcy, a taxpayer may seek to settle a tax liability with the service through the offer in compromise procedure set forth in Code Section 7122.(10)

Should the offer be rejected by the Service or should the taxpayer terminate the offer process, the next step may be a bankruptcy filing. The client must be advised that he cannot discharge the tax which has been the subject of an offer in compromise if the petition for bankruptcy is filed within 240 days after the termination of the offer in compromise process.(11)


Clients seeking the protection of bankruptcy must plan to maximize the discharge benefit that will be derived from the elimination of income tax liability. The practitioner should consider the following checklist in preparation for advising a client and his/her bankruptcy attorney: 1. Have all pre-bankruptcy income

tax returns been filed? 2. Have any returns been the subject

of a fraud penalty assessment? 3. Does the client owe employment

taxes or has he/she been the object

of a Section 6672 penalty

assessment? 4. Has the client had a 6020 substitute

return filed for him/her? 5. Did the client sign the 6020

substitute return? 6. Has the client attempted to settle

his/her tax liability through an

offer in compromise? If so, the

practitioner must examine the

IRS rejection letter or termination

letter for the date of rejection

or termination.


(1) 11 USC 523(a)(A)and507(a)(7)(A)(i) (2) 11 USC 523(a)(1) (3) 11 USC 523(a)(1)(a) and 507(a)(7)(A)(ii) (4) 26 USC 6672 (5) 11 USC 523(a)(7) (6) 11 USC 523(a)(1)(A)and507(a)(7)(A)(i) (7) 11 USC 523(a)(1)(B)and11 USC 523(a)(7)(B) (8) In RE D'AVANZA 89 USTCpara9503, 64 AFTR 2d 89-5611 (BCDC Fla, 1989); In re BERGSTROM 68 AFTR 2d 91-5886 (9) 26 USC 6020(b) (20) 26 USC 7122 (11) 11 USC 507(a)(7)(B)(iii) and 11 USC 523(A)(1)(A)
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Title Annotation:Debits & Credits; circumstances where an individual is not exempt from taxes when filing for bankruptcy
Author:Breakfield, Robert; Alvis, Charles
Publication:The National Public Accountant
Date:Aug 1, 1992
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Next Article:Marital deduction planning: for the non-citizen spouse.

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