Discharging State Income Taxes in Bankruptcy. FTB California State income tax can be burdensome and may contribute to a debtor’s decision to file for bankruptcy. Fortunately, state income tax is dischargeable in bankruptcy taxes under certain circumstances. Those circumstances are largely identical to the circumstances under which federal income taxes can be discharged, as the power of the bankruptcy courts are not affected by whether the taxes are state or federal.
First, the bankruptcy must be filed three years from the date the return was due (including extensions). To give an example, the due date of the 2017 Form 540 (with extension) was October 15, 2018. A 2017 California income tax liability cannot be discharged in bankruptcy until October 15, 2021.
Second, debtors seeking to discharge state income tax must have filed a tax return for the income tax on which they seek to have discharged. That tax return does not have to have been filed on time; a late tax return filing will suffice, as long as the return was filed more than two years before the bankruptcy commences. However, under the current bankruptcy laws, state and federal taxes cannot be discharged in bankruptcy if the IRS or state files a return on your behalf.
Next, the state tax authority must have assessed the state income tax more than 240 days before the debtor files a bankruptcy case. While federal taxes are usually assessed within six weeks of the filing of a tax return, the time between the filing of a tax return and the corresponding assessment will vary from state to state.
Finally, the debtor must not have attempted to defraud the taxing authority by filing a fraudulent return. Even where these requirements are not met, and a debtor is not be able to successfully discharge state taxes in Chapter 7 bankruptcy, it may be possible to force a Chapter 13 payment plan upon a state taxing authority.
When a state income tax debt cannot be discharged, one might attempt to settle it in a number of ways. Installment plans might provide one option to the financially downtrodden taxpayer, and the state taxing authorities are likely to work with taxpayers to allow them to pay in a viable manner. There may even be ways to reduce the overall amount owed to the state taxing authorities. Just as the federal Internal Revenue Service (IRS) has Offer in Compromise options, the state tax authorities may also be willing to settle tax debts with debtors that cannot pay.
Finally, collection reprieves may also be possible, where the debt remains outstanding but the state agrees not to attempt collection of the debts due to financial hardship. As is the case on the federal tax level, state taxing authorities will likely want to see continuing evidence of financial hardship to justify a continuation of a collection suspension.
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