Filing Bankruptcy in Arizona with Tax Debt

The Majors Law Group helps individuals file bankruptcy under the bankruptcy code. If you are looking for a “bankruptcy lawyer near me” the Majors Law Group (located in Tempe and Peoria) can help you file bankruptcy and eliminate tax debt.

Although it is possible to discharge (eliminate) both state and federal income tax debts in Chapter 7 or Chapter 13 bankruptcy, very strict rules apply. Moreover, if the IRS or its state counterpart contests the discharge, the taxing authority need only prevail by a preponderance of the evidence, which means “more likely than not.”

Rules for Discharge of Tax Debts

The rules for discharge are very well-established:Income Taxes Only: Payroll, property, excise, and anything other than income taxes are not dischargeable under any circumstances. The Bankruptcy Code does not really define “tax” or “income tax,” so to prevent discharge, the taxing authority only needs a reasonably compelling reason to classify the tax as something other than income tax, because of the low standard of proof.

Three/Two/240 Rule: The income taxes must be at least three years old (e.g. 2012 taxes were due on April 15, 2013 and thus became dischargeable on April 15, 2016), the returns must have been on file for at least two years (substitute returns normally do not count), and the tax must not have been assessed in the last 240 days (i.e. the taxpayer has not received a letter in the last nine months). The time rules are extremely strict, and bankruptcy courts have been known to deny discharge based on an event that occurred one or more days too early or too late. Penalties and interest are generally dischargeable as well, if they are related to an income tax debt that’s discharged and they are at least three years old.

Tax Fraud Will Prevent Discharge: Courts have consistently ruled that fraud is not a matter of intent but rather a matter of mathematics. Instead of an evil or impure motive, the taxing authority must only show “badges of fraud,” such as:

  • Failure to keep records
  • Large income understatements
  • Failure to cooperate
  • Inconsistent behavior

Bear in mind that the standard is more likely than not, so if the taxpayer fails to return a couple of phone calls, the taxing authority could deem such behavior failure to cooperate, and a bankruptcy judge might very well agree.

Willful Evasion Will Prevent Discharge: A willful failure to pay taxes is intent-based because it involves an acknowledgement that the tax is due but a refusal to pay it. Therefore, taxpayers who file their returns on time and ignore collections notices while they wait for the clock to tick down in bankruptcy may be ineligible for discharge.

Effect of Discharge

Although a debt is legally forgiven, if the taxing authority obtained a lien against the taxpayer’s property for unpaid income tax, bankruptcy does not release the lien. The lien will have to be paid before the property can be sold with clear title.

Effect of Filing Bankruptcy on Tax Collection Efforts

The automatic stay does not stop all tax collection proceedings. For example, if a taxpayer filed bankruptcy and owed federal or state income taxes, the taxing authority could still:

  • Offset his tax refund
  • Audit him
  • Assess unpaid taxes and demand payment
  • Issue a notice of delinquency
  • Demand his tax returns

The automatic stay has no effect whatsoever if the taxing authority does not receive the proper notice of the bankruptcy filing at the proper address.

What About Income Tax Refunds?

Procedures vary by jurisdiction, but most trustees send letters to all debtors in bankruptcy in the late spring of each year demanding their tax returns for the current year. If the debtor expects an income tax refund from the previous year, such a windfall is typically property of the bankruptcy estate.

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