Most entrepreneurs go into business with the intention of building a strong and successful enterprise. Not all businesses, however, will make it even through the first year. According to the Small Business Administration Office of Advocacy, about 20% of businesses won’t last beyond their first year, and about 50% will close within five years. Small business closures are often due to circumstances outside the business owner’s control. A current case in point is the havoc wrought on many small businesses by the COVID-19 pandemic. When it becomes impossible to carry on with business as usual, it may become necessary to declare bankruptcy. But how does bankruptcy affect tax obligations?
Declaring bankruptcy does not automatically relieve small business owners of their IRS tax obligations. However, in some cases there are ways to work with tax authorities and, within the framework of bankruptcy laws, to minimize the burden of owing taxes for a business that has declared bankruptcy. Let’s look at some details.
Got a legal question?
Get legal advice in minutes. Real Lawyers. Real Answers. Right Now.
May I discharge taxes if my business has filed for bankruptcy protection?
The short answer is that small business owners are responsible for paying taxes owed when declaring bankruptcy. But there are certain circumstances under which debtors may discharge, or cancel, tax obligations during bankruptcy proceedings.
There are different types of bankruptcies that are named for different sections of the tax code. You cannot file your tax return and then immediately declare bankruptcy and request discharge of your tax debts, regardless of the type of bankruptcy you have filed. The rules regarding discharge of tax debts allow for the possible discharge of taxes when those taxes were due at least three years before filing for bankruptcy, and only if it has been at least two years since you filed a tax return for your business. In addition, at least 240 days must have elapsed since the time the IRS assessed the taxes.
You must have filed the business’ most recent four tax returns with the IRS, no later than the first creditors meeting for the bankruptcy matter, before a discharge is granted.
How are back taxes and unfiled tax returns handled in a business bankruptcy filing?
You may not discharge, or cancel, taxes that are owed for tax periods in which tax returns were not filed. However, you may be able to discharge some back taxes owed when you declare business bankruptcy.
If your business has not filed taxes for the past three tax years, the IRS may cancel your debt for the previous tax periods. This relief is not automatic, but may be achieved by working with an attorney who can apply for it and negotiate on your behalf. The three-year rule applies to when taxes were due, but you may have filed your tax return for that tax period as recently as two years before filing for bankruptcy. This two-year test may come into play if you filed your tax return late.
Will I still be charged a penalty if my business is behind on taxes at the time of my bankruptcy filing?
You might be able to get late payment penalties discharged, or canceled, by the IRS in a business bankruptcy proceeding, even if the tax debt itself does not meet the time requirements for discharge outlined above.
Tax penalties that are more than three years old are generally dischargeable. However, it may not be as easy to discharge penalties that are tied to a tax debt for which the IRS or another tax authority has obtained a tax lien. Also, as a general rule, interest on tax debt is dischargeable if the tax debt itself is dischargeable.
Penalties on tax debt that is not eligible for discharge under the tax code are treated differently, depending on the type of bankruptcy you are filing. Penalties and interest on such tax debt are not dischargeable under a Chapter 7 bankruptcy, but might be under different chapters. Your bankruptcy attorney can help you evaluate the pros and cons of various approaches, depending on your situation.
Are there other ways to limit my company’s tax obligations during bankruptcy?
You might not be able to discharge all (or any) of your business’ tax obligations, but you may have other options for dealing with your debt if you are behind on taxes when you decide to declare bankruptcy. Sometimes, it makes sense to work out installment payment plans with the IRS or enter into an agreement to pay a reduced amount, called an “Offer in Compromise.”
In addition, the CARES Act passed in March 2020 revised the U.S. Bankruptcy Code to make it easier for some business owners to declare Chapter 11 bankruptcy, which has historically not been a realistic option for many small business owners. Under Chapter 11 reorganizations, business owners may be able to extend their timeframe for payment of unsecured tax debts for up to five years.
The CARES Act bankruptcy code changes are scheduled to expire in March 2021, as of the date of this article. Talk to your attorney to explore whether and to what extent these changes could benefit you if you are planning on filing a bankruptcy petition before these beneficial Chapter 11 code changes expire.
Seek guidance and understand your options
Declaring bankruptcy for a small business you have invested your time and energy into is rarely an easy decision, but sometimes it is the best option. Understanding how various types of debts will be handled, including tax obligations, can help you evaluate which type of bankruptcy filing makes the most sense.
Note that the information provided above relates solely to legitimate federal income tax obligations. Business owners may not discharge payroll taxes in a bankruptcy proceeding, nor may they discharge taxes related to fraudulent tax filings or willful tax evasion.Business bankruptcies are often complex. Fortunately, help is available. Talk to a Rocket Lawyer On Call® attorney about how your company’s income tax debts may be handled in a bankruptcy proceeding.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.