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.
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.
How Can Tax Penalties Be Discharged in Bankruptcy?
Here is a common example; tax debtor comes to me and tells me he has not filed tax returns for 8 years. Immediately, I already know none of the resulting tax debt will be dischargeable. The best advice I can give the tax debtor is to 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 taxpayer are the failure to file a timely return and failure to pay. Bankruptcy will eliminate the majority of that penalty; reason being, the failure to file and failure to pay penalties 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. I 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 discharged in bankruptcy if the alleged fraudulent tax returns were filed more than three years prior to 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.