3-2-240 Rule

The 3-2-240 Rule is a shorthand reference to the time-related criteria that tax debts must meet to be considered dischargeable in bankruptcy. It encompasses three critical timelines related to the tax return’s due date, the actual filing date, and the IRS’s assessment of the tax debt. Let’s break down each component:

The Three-Year Rule

The first part of the rule stipulates that the tax debt must be related to a tax return due at least three years before the bankruptcy filing, including any extensions.

The Two-Year Rule

The second component requires that the tax return was actually filed at least two years before the bankruptcy petition. This rule emphasizes the importance of filing tax returns, even if you can’t pay the tax owed at the time. It’s crucial to note that this applies to returns filed by the taxpayer, not substitute returns filed by the IRS on behalf of a taxpayer who failed to file.

The 240-Day Rule

Finally, the tax debt must have been assessed by the IRS at least 240 days before filing for bankruptcy or not assessed at all. This part of the rule accounts for the IRS’s actions in determining the amount owed. The assessment period can be extended if the IRS suspended collection activity due to an offer in compromise or a previous bankruptcy filing.

Exceptions and Considerations

While the 3-2-240 Rule provides a framework for discharging certain tax debts, there are exceptions and additional considerations:

– Fraud and Willful Evasion: Tax debts related to fraudulent tax returns or willful attempts to evade taxes are not dischargeable, regardless of the 3-2-240 Rule.

– Tax Liens: If the IRS has placed a tax lien on your property before you file for bankruptcy, the lien may remain attached to the property, even if the underlying tax debt is discharged. Federal Tax Liens can’t be discharged. If the IRS recorded a tax lien on your property before you file for bankruptcy. You’ll have to pay off the tax lien, which you may be able to do in Chapter 13.

– Non-Dischargeable Taxes: Certain taxes, such as payroll taxes or penalties related to non-tax debts, are not dischargeable in bankruptcy.

Navigating Your Bankruptcy and Tax Debt Strategy

Understanding the nuances of the 3-2-240 Rule and its application to your specific situation requires careful analysis and strategic planning. Here are steps to consider:

1. Review Your Tax History: Assess your tax returns, payments, and IRS assessments to determine if your tax debts meet the 3-2-240 criteria.
2. Consider Timing: The timing of your bankruptcy filing can significantly impact the dischargeability of tax debts. Strategic planning can maximize the debts eligible for discharge.

Late Filed Returns

Filing timely tax returns is key if you wish to discharge tax debt in bankruptcy.  If you’re anticipating tax troubles on the horizon, it is always best to go ahead and file a tax return. Failure to do so can result in the IRS preparing a “Substitute for Return” and wildly overestimating your tax bill. If the Substitute for Return becomes final and the taxes are formally assessed, you lost your ability to discharge your tax debts in bankruptcy. Section 523 of the bankruptcy code provides as follows:

(a) A discharge under section 727 . . . of this title does not discharge an individual debtor from any debt —(1) for a tax or a customs duty — . . .(B) with respect to which a return, or equivalent report or notice, if required —(i) was not filed or given. . . .

In Re Smythe

A decision out of the United States Bankruptcy Court in Tacoma, Washington, In Re Smythe, holds that debtors who fail to file a tax return before the IRS issues an assessment lost their ability to discharge assessed taxes in bankruptcy.  The IRS argued that it was their assessment, not the subsequent filing of the 1040, that created the tax debt. The IRS assessed debt was one in which no return was filed or given, therefore the debts were non-dischargeable under section 523. The Court agreed with the IRS argument.