Can Income Taxes be Eliminated if the IRS Still Has the Right to Assess a Deficiency?

No, income taxes cannot be discharged or eliminated in bankruptcy if the taxing authority still has the right to assess a tax.  Section 523(a)(1)(A) of the Bankruptcy Code identifies certain types of income taxes that are non-dischargeable in bankruptcy by incorporating §507(a)(8)(A) of the Bankruptcy Code.  Section 507(a)(8)(A) excepts from discharge any income taxes that are assessed within 240 days of the bankruptcy filing, or are assessable under applicable non-bankruptcy law after the bankruptcy case is filed.

The US Court of Appeals for the Seventh Circuit addressed this issue in U.S. v. Frontone, 383 F.3d 656 (7th Cir. 2004).  In Frontone, a taxpayer had filed a tax return and paid the tax owed as required by the IRS Code.  However, the IRS made an error and wrongly tendered a tax refund to the taxpayer.  The IRS later realized its error and issued a supplemental assessment for the deficiency caused by the tax refund.  The IRS compounded the error by making another error—namely, issuing a supplemental assessment without issuing a notice of deficiency.

The taxpayer filed bankruptcy in an effort to discharge the tax debt caused by the tax refund.  The Frontone court denied the taxpayer’s quest for a discharge because the tax obligation was assessable at the time the bankruptcy case was filed. First, the court found that the IRS’ supplemental assessment was in error because it had not followed a “notice of deficiency.”  But that did not save the taxpayer because the court found that the IRS eventually filed the required notice of deficiency within the time period allowed as provided by the IRS Code (even if it was after the bankruptcy filing).  Therefore, since the notice of deficiency was finally issued correctly, the Frontone court found the tax refund obligation non-dischargeable because the tax debt was “assessable” on the date the bankruptcy case was filed.

Practice Pointer:   Best practices requires a careful analysis of the tax filing deadlines and the Bankruptcy Code’s statutory waiting periods.  Taxpayers must wait to file bankruptcy at least 240 days after the IRS assesses the tax, AND wait beyond the statutory assessment period if the IRS has not yet assessed a tax so that the tax becomes non-assessable.

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