The general rule is that income tax, both Federal and State, are discharged in bankruptcy if the return is at least 3 years old before the bankruptcy is filed, and the tax has been assessed at least 240 days pre-filing. In addition, there must be no fraud involved. If the return is filed late, the computation of the 3-year period is extended accordingly. For instance, you owe $50,000 of income taxes to the IRS and $5,000 to the state for income tax returns that were filed on April 15, 2008. You file for chapter 7 bankruptcy on May 15, 2011. Is the $50,000 owed to the IRS discharged? Yes. Is the $5,000 owed to the State discharged? Yes. But what if you filed your chapter 7 case on April 10, 2011? That would be a different story. In that situation, both the $50,000 owed to the IRS, and the $5,000 owed to the State would not be discharged because the time period between April 15, 2008 and April 10, 2011 is less than 3 years.
But what if you reported an income adjustment to the IRS but you failed to report that income adjustment to the State? Let’s find out. In Re Ciotti, debtor filed Maryland state income tax returns in 1996 for the 1992, 1993, 1994, 1995 and 1996 tax years. In 1998, the IRS made adjustments to the debtor’s federal returns, significantly increasing her federal adjusted income for each of the 1992 to 1996 tax years. Because Maryland’s taxable income is based upon federal adjusted income, the debtor was required under Maryland law to report the amount of the changes to her federal adjusted income to Maryland tax authorities. The debtor did not inform the state of the changes, but the IRS did. Based on the information provided by the IRS, the state determined that the debtor owed more than $500,000 in taxes, penalties, and interest. It’s pretty much like winning the lottery in reverse. This is called the IRS LOTTO.
In 2007, the debtor filed for and received a chapter 7 discharge. In February 2009, the debtor’s bankruptcy was reopened, and the bankruptcy court ruled that her state tax liabilities were discharged. The District Court reversed, concluding that the taxes were not discharged pursuant to Section 523(a)(1)(B) because the debtor failed to report the increase in her federal adjusted income. The 4th Circuit Court of Appeals affirmed. “In 2005, Congress, attempting to reduce the spiraling cost to society of bankruptcies, enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005,” the panel said. “In amending Section 523(a)(l)(B) in particular, Congress made it applicable not only to the failure to file a required return, but also to the failure to file or give an ‘equivalent’ required ‘report or notice.’… It is apparent from the changes that Congress determined that the same policy reasons that justify precluding the discharge of tax debt when the debtor failed to file a return also justify precluding the discharge of the tax debt when the debtor failed to file or give a required report or notice corresponding to that debt.”
Section 523(a)(1)(B) provided that a debt for a tax is not discharged if “with respect to which a return, or equivalent report or notice, if required (i) was not filed or given; or (ii) was filed or given after the date on which such return, report, or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition…”
Winning the IRS LOTTO is not unusual. I don’t know what the odds are but I have had at least 5 clients in the past who owe the IRS several million dollars. While winning the normal lottery can make you feel and look younger, the reverse IRS LOTTO, will do exactly the reverse, it will make you feel and look years older. If you still have hair, you will lose all of it after reading the IRS letter.
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Lawrence Bautista Yang specializes in bankruptcy, business, real estate and civil litigation and has successfully represented more than five thousand clients in California. Please call Angie, Barbara or Jess at (626) 284-1142 for an appointment at 1000 S Fremont Ave Bldg A-1 Suite 1125 Unit 58 Alhambra, CA 91803.
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