IRS Debt in Bankruptcy: The Three-Year, Two-Year and 240-Day Rules

You owe the IRS for several years of income tax, and the penalties and interest keep adding up. One person told you taxes can never be wiped out in bankruptcy. Another told you they can.

Both are partly right. Older income taxes can be discharged if each year passes three timing tests, and many people who owe the IRS have at least some years that pass. Recent taxes, unfiled years and payroll withholding are a different story.

Can bankruptcy really wipe out income taxes?

Yes, for income tax that meets the rules below. A discharge, the court order that ends your personal liability on a debt, can wipe out a qualifying income tax year the same way it wipes out a credit card.

Each tax year is tested on its own. You may owe for five years and find that three can be discharged and two cannot.

What are the three timing tests?

A year of income tax can generally be discharged only if it passes all three:

• The three-year rule. The return was due, including any extension, more than three years before you file bankruptcy.
• The two-year rule. You actually filed the return more than two years before you file bankruptcy.
• The 240-day rule. The IRS assessed the tax, meaning formally recorded it on your account, more than 240 days before you file bankruptcy.

Fail one test and that year is not discharged. Every test is measured back from the day you file, so a few weeks of waiting can move a year from one column to the other.

An extension moves the starting line. If you got an extension, the three years run from the extended due date, not the original one.

Audits and amended returns can restart the 240 days. If the IRS assessed more tax later, the extra amount has its own assessment date, and that date is the one that counts for the extra tax.

What if I filed late, or never filed?

Late is not always fatal. In most courts, a return filed late can still pass the two-year rule once two years have passed since you filed it.

Never filed is different. Tax for a year with no return on file cannot be discharged, however old the debt is.

A return the IRS made for you does not count. If you didn’t file and the IRS calculated the tax on its own, often called a substitute for return, that is not treated as your return in bankruptcy.

Courts have not all treated late returns the same way, especially returns filed after the IRS already assessed the tax. If any of your returns were late, the exact dates matter, and I check them year by year.

Which tax debts never go away?

Fraud and evasion. Tax for a year in which you filed a fraudulent return, or willfully tried to evade or defeat the tax, is not discharged, no matter how old it is.

Trust fund taxes. These are taxes someone was required to collect or withhold from others, such as income tax and the employee’s share of Social Security withheld from workers’ paychecks. They are not discharged in Chapter 7 or Chapter 13, and the rule reaches you personally if the IRS holds you responsible for a business’s unpaid withholding.

Taxes after you file. Taxes for periods after the bankruptcy is filed are not discharged.

Can anything pause the clocks?

Yes. Certain events stop the three-year and 240-day clocks from running, which pushes back the date a year becomes dischargeable.

• A prior bankruptcy. The time the automatic stay, the court order that stops collection, was in effect in an earlier case does not count, plus 90 days.
• An IRS collection hearing. If you asked for a hearing or appeal on a levy or lien and the IRS was barred from collecting while it was pending, that time does not count, plus 90 days.
• An offer in compromise. The time an offer in compromise, a proposal to settle the tax for less, was pending or in effect does not count toward the 240 days, plus 30 days.

If you have filed bankruptcy before, made an offer or asked for an IRS hearing, bring the dates.

What happens to an IRS tax lien?

A discharge ends your personal liability, but it does not remove a valid tax lien. If the IRS properly filed a notice of federal tax lien before your case, the lien survives.

The lien can stay attached to property you owned when you filed, even property bankruptcy otherwise protects, like your home or a retirement account. So a tax year can be discharged and still have to be paid off when you sell or refinance.

If you have received a notice of federal tax lien, tell me before you choose a chapter.

How does Chapter 13 handle IRS debt?

Chapter 13 is a three- to five-year repayment plan. Taxes that fail the timing tests are usually priority debt, meaning debt the law puts ahead of other unsecured debt, and the plan has to pay priority taxes in full unless the IRS agrees otherwise.

That sounds worse than it is. The plan stops IRS levies and garnishments while you pay over three to five years, on a schedule the court approves.

Older taxes get cheaper. Tax years that pass the timing tests are usually treated like credit cards, paid only what the plan can afford, with the rest discharged at the end.

Liens get paid as secured claims. A tax lien is treated as a secured claim, generally paid through the plan up to the value of the property it is attached to.

The Chapter 13 discharge has limits too. It does not cover trust fund taxes, unfiled years, late returns filed within two years before the case, or fraud, so those survive unless they are paid.

You must be caught up on filing. You have to file every tax return for the four years before your case, no later than the day before your first meeting with the trustee. Missing that can block the plan, and so can falling behind on current taxes during the case.

If the IRS is one of your creditors, read the claim it files closely.

Do Maryland and Virginia income taxes follow the same rules?

Generally, yes. The bankruptcy timing tests apply to income tax owed to any government, including Maryland and Virginia, and the Bankruptcy Code’s definition of a return covers state returns as well as federal ones.

But each state keeps its own records. Your state return may have been filed on a different day than your federal return, and the state may have assessed the tax on a different date, so every state year has to be checked separately.

How do I find out which of my years qualify?

Start with dates, not balances. For each year you owe, I need the due date, the date you filed, the date the tax was assessed, and anything that paused the clocks.

I start with your IRS account transcripts, which show what the IRS has on file for each year, including changes made after you filed. You can order them from the IRS online or by mail.

Sometimes the right move is to wait. If a large tax year becomes dischargeable in a few months, filing after that date can change the result, but if a levy is already taking your pay, waiting may cost more than it saves. That timing question is the same one every filer faces, with tax dates added.

What should I do right now?

If you owe the IRS or the state for one or more years of income tax, call me at (202) 448-5136. Bring your IRS notices and a list of the years you owe and when you filed each return.

If you already have a bankruptcy case open, call the lawyer handling it first. Before you make an offer in compromise or request a collection hearing, talk to a lawyer, because each of those can move the dates.

The consultation is free. I handle bankruptcy in DC, in Maryland at the Greenbelt courthouse, and in the Eastern District of Virginia, including Chapter 13 cases built around tax debt.

Don’t wait. A few weeks either way can decide which years are wiped out.