Discharging Tax Interest and Penalties in Bankruptcy

January 3, 2011

By: David M. Serafin

As an attorney practicing both bankruptcy and tax law in Denver, my firm attracts a high number of clients who simultaneously owe both tax and non-tax (e.g. credit card, medical bills, debt resulting from foreclosure or a repossession) debt.  The common question which arises is whether a tax debt can be discharged.

Other articles on my website discuss the potential discharge of the underlying tax (which is eligible for discharge if: an income tax, the income tax return was filed 2 years or more before the bankruptcy petition is filed, the tax year is three or more years prior, and no assessment has occurred within the 240 days prior to the bankruptcy filing).  

But, it’s not only the underlying tax owed but also accompanying interest and penalties (most commonly from failure to file a tax return and/or pay taxes).  Often, various tax penalties which exponentially increase over the years can eventually exceed the original, underlying tax debt itself thereby creating a situation where a potential bankruptcy debtor, absent full discharge of the tax, interest and penalties, is unable to pay back most or all of what’s owed.

Here’s a bit of good news for bankruptcy debtors in Colorado: pre-petition tax penalties (which have accrued up until the date of the bankruptcy filing) are not deemed by Section 523(a)(7) of the Bankruptcy Code to be a Priority debt (which is required to be paid back in full directly to the tax authority in a chapter 7 or required to be paid back in full over 3-5 years in a chapter 13 plan) if incurred over three years prior to the bankruptcy being filed.  Rather, pre-petition tax penalties are classified as unsecured, non-priority debt (akin to credit cards, medical bills, debt resulting from foreclosure or a repossession) which can be fully discharged in a chapter 7 or paid back “pennies on the dollar” and interest and penalty free in chapter 13.  (The one exception to any tax penalties being unsecured is that the IRS or Colorado State Dept. of Revenue did not first file a tax lien on real property in the county of residence before the bankruptcy filing, thereby rendering such penalties secured and to be fully paid back, plus interest.)

In comparison, assuming the tax debt (including interest and penalties) is not secured by a Colorado state or Federal tax lien, any imposition of post-bankruptcy petition interest and penalties is permanently stayed assuming the bankruptcy debtor is eligible for a full discharge in a chapter 7 or fully completes the 3-5 year payment plan in a chapter 13, and obtains an order of discharge.  (The IRS will continue to allow interest and penalties to accrue, wait for the discharge order to enter 3-5 years after filing, and then abate interest and penalties, assuming that plan payments have been timely and fully made.)

In contrast to any tax penalties assessed, the interest follows the underlying tax debt in that interest can only be discharged if the underlying tax can be discharged, regardless of whether a chapter 7 or chapter 13 bankruptcy is filed in Colorado.

When a prospective client has a tax issue, I always advise that any unfiled income tax returns need to be immediately filed.  (An obvious sign that a tax issue exists is if the debtor has unfiled tax returns for years in which any income is significant – where a tax liability, plus interest and penalties will be owed once the tax is formally assessed.) Once the taxpayer/bankruptcy debtor files the tax returns, we can segregate the underlying tax, interest and penalties into a dischargeable or non-dischargeable category on the schedules.

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