Can Tax Penalties Be Eliminated in Bankruptcy?

Yes, if the event that gave rise to the penalty occurred more than 3 years prior to the debtor filing bankruptcy. Bankruptcy code section 523(a)(7) is a remarkably powerful tool in dealing with tax debt, and few practitioners realize its potency to help a tax debtor.

Even if the underlying tax debt is not dischargeable (usually because the debtor did not file the tax return 2 years prior to filing bankruptcy), the associated tax penalties may be dischargeable; which is especially helpful for older tax years since penalties compound over time.

A frequent example; tax debtor comes to you and tells you he has not filed tax returns for 8 years. Immediately, you already know none of the resulting tax debt will be dischargeable. The best advice you can give the tax debtor is file the returns; and he does. The tax debtor now has $50,000 in tax debt with interest and another $21,000 or so in penalties. The penalties faced by the tax payer are the failure to file a timely return and failure to pay. A bankruptcy will knock out the majority of that penalty; reason being, the failure to file and failure to pay relate back to when the tax return was due. So, for the older tax years in question, the penalties will be dischargeable in bankruptcy even though the underling principal tax debt is not.

Even more powerful, this code provision applies to all tax penalties. Myself and former associates have used this provision to discharge the IRS Civil Fraud penalty (IRC § 6663). The Civil Fraud penalty is the most serious non-criminal action the IRS can levy against a taxpayer. The Civil Fraud penalty relates to a tax return filed by the taxpayer that was intentional fraudulent leading to an underpayment of tax. The penalty amount is 75% of the principal tax. So, if you have a taxpayer owing $500,000 in tax, the IRS assessed Civil Fraud penalty of $375,000 can be knocked out in bankruptcy if the alleged fraudulent tax returns were filed more than three years prior the tax debtor’s bankruptcy.

So, even if the principal tax debt is non-dischargeable, bankruptcy may be an ideal solution to reducing the overall debt the taxpayer owes thereby making it easier to achieve a non-bankruptcy solution to the tax debt.

BankruptcyTaxDischarge.com provides full service consulting for all your bankruptcy and tax related issues.

Matt Berkus - Expert in Bankruptcy Tax Discharge

 By: Matt Berkus