Automatic Nondischargeability of Tax Debts

Tom Wolfe Headshot
Tom Wolfe, Managing Partner of Moore Brewer Wolfe Jones Tyler & North.

With tax season upon us, this is a good opportunity to review the impact the filing of bankruptcy has on a loan incurred to pay a tax debt.  If a member takes out a loan to pay off a tax debt, and that member ultimately ends up filing bankruptcy before that loan is paid back, there is a possibility that the loan will not be discharged.  This is because bankruptcy laws generally prohibit the discharge of a debt incurred to pay off an otherwise nondischargeable tax debt. 

However, if the underlying tax debt meets certain criteria, it can still be wiped out in the bankruptcy, as can the debt incurred to pay off these taxes, leaving the credit union to bear the loss.[i] To be dischargeable, all five of the following criteria must be met:

1. Must Be Income Tax Debt

Debtors may only discharge income taxes in bankruptcy.  Other taxes, such as payroll taxes, or fraud penalties do not qualify to be eliminated in bankruptcy.  Any interest accrued on dischargeable income tax debt may be wiped out as well, and associated penalties may be dischargeable even if the tax debt is not.  Penalties must only meet the three-year rule. This means that, even if the penalties qualify for discharge, the debtor might still owe the debt attributable to the underlying tax bill and interest because they don't meet one or more of the other five rules for discharge.

2. Due Three or More Years Ago

In order for the tax debt to be dischargeable, it must have been due at least three years prior to filing bankruptcy (including any extensions).  For example, if a member files for bankruptcy in February 2019, that member’s tax debt for 2018, 2017 and 2016 would not be eligible for discharge, but all tax debts from the years prior to 2016 would be eligible for discharge.

3. Return was Filed Two or More Years Ago

In order for the tax debt to be dischargeable, the tax debt must have been the result of a tax return that was filed at least two years prior to filing bankruptcy. This is an extremely fact-specific determination that may require an investigation (or formal discovery) to determine exactly when a return for a specific year in question was filed. That filing date is the measuring date.

4. Tax Assessment is 240 or More Days Old

In order for the tax debt to be dischargeable, the tax debt must also have been assessed at least 240 days prior to filing bankruptcy, with some exceptions that could extend that time limit, such as an agreed-upon offer in compromise with the IRS.

5. No Fraud or Willful Evasion

The filed tax return must not have been fraudulent (e.g., using someone else’s Social Security Number). Moreover, the debtor must not have willfully evaded paying his or her taxes, such as by deliberately reporting less income than what was earned or deducting fictitious expenses.

If a debtor’s tax debt satisfies all the above requirements, it may be eligible for a complete discharge in a Chapter 7. Depending on income and assets, the debtor will generally be required to repay some or all of the tax debt through a Chapter 13 plan.  If a credit union is contemplating making a loan for the express purpose of repaying the debtor’s tax debt, we recommend ensuring that there is no question that this is the loan’s purpose.  For example, the credit union should make sure the application clearly expresses that the loan is intended to pay a tax debt and request a copy of the applicable tax assessment showing the years for which the taxes are due.  To the extent possible, the credit union should also arrange to disburse the loan proceeds directly to the U.S Treasury or Franchise Tax Board instead of disbursing them to the member, and keep a copy of the disbursement record.

If the credit union has already made such a loan and that debt does not meet all the above requirements for discharge, it is likely that the loan remains nondischargeable (without the need for a court determination) and collectible. The credit union is urged to work with its own counsel and contact the debtor’s attorney to ensure that all parties understand the potential dischargeability of both the tax debt and the loan debt.

[i] 11 U.S.C. §§507, 523.

Article by Tom Wolfe, Managing Partner of Moore Brewer Wolfe Jones Tyler & North.

Pin It