Discharging Tax Liabilities In Bankruptcy
Series: Dealing With The IRS Collection Division
© by Burton J. Haynes, Esq.
This is the fourth in a series of articles about dealing with the IRS Collection Division. In previous articles we discussed innocent spouse relief, installment agreements, and offers in compromise. All of these are useful techniques for dealing with tax liabilities which should not be collected from your client, or which exceed your client's ability to pay. But there are situations in which these devices are unavailable, inappropriate or inadequate. And in these cases, relief can sometimes be obtained through bankruptcy. Bankruptcy can be useful in contesting the amount or validity of a tax liability when other judicial forum cannot be used. And most importantly, a properly timed and structured bankruptcy can discharge many tax liabilities, thus giving a financially distressed individual a "fresh start."
Right up front we need to address a common misconception. More than a few otherwise knowledgeable accountants and lawyers will vigorously assert that taxes are not subject to discharge in bankruptcy. For certain tax debts which enjoy a "priority" status under the Bankruptcy Code, this is true. But under the proper circumstances, many tax liabilities lose their priority status, and enjoy no greater protection from discharge than debts owed to any other creditor. In the pages below we will discuss the statutory provisions differentiating priority from nonpriority taxes so that you will be able to tell which tax liabilities are potentially subject to discharge and which are not. And while no article of this length can possibly make you an expert in the tax aspects of bankruptcy, it is hoped that you will at least come away with an increased sensitivity for those situations in which bankruptcy might present a useful alternative worthy of further exploration.2
Types of Bankruptcies.
Two forms of bankruptcy are typically used by individuals:3 Chapter 7 and Chapter 13.4
A Chapter 7 is a traditional "liquidating" bankruptcy. A trustee is appointed for the principal purpose of protecting the unsecured creditors. Secured creditors don't require the same degree of judicial concern -- they have already protected themselves by becoming secured creditors in the first place. Under the supervision of the trustee, and subject to certain statutory exemptions, the debtor's assets are marshalled and sold.5 Assets which are fully encumbered by the claims of secured creditors are usually abandoned by the trustee to the secured creditors or to the debtor, subject to those liens, since such fully encumbered assets are of no benefit to the unsecured creditors.
A Chapter 13 is for a small debtor with regular income who can make monthly payments against his or her debts. In order to "qualify" to use Chapter 13, a debtor must have unsecured debts of less than $269,250 and secured debts of less than $807,750.6 Under a Chapter 13 "plan," the debtor makes monthly payments to a trustee, who distributes the money, less a commission, to the creditors.7 To be "confirmable," a Chapter 13 plan must provide for the full payment of all priority debts.8 At the conclusion of the required series of monthly payments, all dischargeable debts which remain unpaid are discharged.9
Tax Treatment of the Debtor and the Bankruptcy Estate.
Separate Taxable Estate.
Under Internal Revenue Code §1398, added by the Bankruptcy Tax Act of 1980, the filing of a bankruptcy petition by an individual under Chapter 7 creates an "estate" which is treated as a separate taxable entity.10 The estate files its own tax returns and pays taxes on its own income.11 The transfer of an asset between the debtor and the estate is not treated as a disposition, and thus typically has no separate tax consequences. In contrast, while the filing of a Chapter 13 action creates an estate for purposes of the Bankruptcy Code, the estate is not treated as a separate taxable entity for tax purposes.
Treatment of Tax Attributes.
It is important to know that in addition to receiving the debtor's assets, a Chapter 7 estate succeeds to the debtor's "tax attributes."12 This includes the basis, character and holding period of assets, net operating losses, capital losses, suspended passive losses, and various tax credits. These transfers are deemed to occur as of the first day of the debtor's taxable year in which the petition is filed. Because these tax attributes are transferred to the bankruptcy estate, they are thereafter no longer available to the debtor. The estate also succeeds to the debtor's right to file refund claims to recover taxes paid in prepetition years.13 At the conclusion of the bankruptcy case, the estate's unused tax attributes are transferred back to the debtor.14 Planning how to best structure and time the proposed bankruptcy in light of these attribute transfer and reduction rules requires both a thorough knowledge of the rules and more than a little creativity.
Election to Close Tax Year.
The filing of a bankruptcy petition does not cut off the debtor's tax year.15 This means that if a petition is filed late in the year, the debtor can be left with responsibility for taxes on his prepetition income, even though his assets are transferred to his bankruptcy estate upon filing of the petition. However, an election to bifurcate the debtor's tax year is available.16 If the election is made, the debtor's taxable year ends on the day before the petition is filed, and a new taxable year starts on the petition date. Deciding whether to make this election is an important issue which can have a significant impact on the outcome of the case. In essence, the election permits the debtor to shift responsibility to the estate for taxes on income earned before the petition date.
Where the estate has assets which might otherwise be applied to debts owed to general unsecured creditors (including dischargeable tax debts for earlier years), bifurcating the tax year can cause those assets to be applied instead to the taxes owed for the short prepetition year -- taxes which if unpaid would survive the bankruptcy to be paid out of the debtor's postpetition income. The election also permits the debtor to use his tax attributes, such as the basis in depreciable assets and net operating loss carryforwards, to reduce the tax on the prepetition income. Absent the election, these tax attributes would be lost as of January 1st of the year in which the petition is filed, as explained above.
As with so many other aspects of the complex interface between bankruptcy law and tax law, the IRC §1398(d)(2) election presents both planning opportunities and traps for the unwary. The election must be made on or before the due date of the tax return for the short pre-petition year, and this date cannot be extended. Furthermore, the election is irrevocable once made.17 The return for a tax reportable on an annual basis is typically due by the 15th day of the fourth month following the close of the year. Because in this situation the taxable year can end on a day other than the end of a month, the filing deadline for the short year is the 15th day of the fourth full month following the petition date.18
Effect of Bankruptcy on IRS Collection Action.
Filing a bankruptcy petition is like holding a crucifix in front of a vampire. Immediately upon filing, an "automatic stay" arises under BC §362(a), and all IRS enforced collection action must cease.19 As soon as it learns of the filing of a bankruptcy petition, the IRS posts its computer system with a "bankruptcy hold" code to avoid inadvertent violation of the automatic stay. Nevertheless, because of changes made by the Bankruptcy Reform Act of 1994, the IRS is now allowed to take some limited steps to determine and assess tax debts despite the filing of a petition. The permitted actions include the following:
- Demanding that any delinquent returns be filed;
- Auditing the taxpayer's returns;
- Issuing a statutory notice of deficiency;
- Assessing uncontested liabilities and prepetition taxes shown on the taxpayer's returns;
- Refiling a notice of federal tax lien;
- Issuing summonses to determine the tax liability.
It is unfortunately true, however, that the IRS routinely violates the automatic stay. Usually this is the result of inadequacies in the IRS's computer system.20 Like the malevolent computer HAL in the movie "2001 - A Space Odyssey," the IRS computer system often proceeds with automated collection action despite the posting of a bankruptcy hold code:
IRS's failure to correct known, glaring weaknesses in its internal controls which cause it to repeatedly violate the automatic stay constitutes bad faith and an arrogant defiance of the majesty of the Federal Law which has embodied 11 U.S.C. section 362 as its "fundamental protection" to debtors in bankruptcy. In re Flynn, 169 B.R. at 1024.
A typical computerized action violating the automatic stay is the Service's practice of offsetting a current period refund against a prior period delinquency. Even though the Internal Revenue Manual acknowledges that the automatic stay bars refund offsets unless and until a lift stay order is obtained from the Bankruptcy Court, it is not uncommon to find that the IRS has offset a postpetition refund against a prepetition tax debt. In an effort to convince the IRS to be more punctilious about such matters, the new IRS Restructuring and Reform Act allows damages of up to $1,000,000 for violations of the automatic stay.21
When a Revenue Officer learns of the filing of a bankruptcy petition, he or she packs up the case file and ships it to the Special Procedures Office.22 Special Procedures then files a proof of claim in the bankruptcy case when appropriate and, in consultation with District Counsel when necessary, determines what other actions are needed to protect the government's interests. The automatic stay remains in place until the discharge is entered at the conclusion of the case. At that point the automatic stay is converted into a permanent injunction barring any effort on the part of a creditor, including the IRS, to collect a discharged debt.
Classifying Tax Debts.
Secured vs. Unsecured.
In bankruptcy, the Internal Revenue Service, despite its Draconian collection powers, is just another creditor. It can be secured creditor if a Notice of Federal Tax Lien has been filed. Or it can be an unsecured creditor if no lien has been filed. Finally, the IRS can be partially secured and partially unsecured if a lien has been filed but the amount of tax owed exceeds the taxpayer's equity in the property covered by the lien.23
Priority vs. Nonpriority.
Apart from the question of whether the IRS is secured or unsecured, tax debts (like other debts) have to be categorized as to their priority. Certain taxes are given a higher priority in bankruptcy than that of most other commonly encountered debts. Section 507(a)(8) of the Bankruptcy Code gives this priority status to income taxes under the following circumstances, thus effectively making them nondischargeable in the typical Chapter 7 bankruptcy:
507(a)(8)(A)(i) -- Taxes are nondischargeable if the return was last due (with extension) less than three years prior to the filing of the bankruptcy petition.
507(a)(8)(A)(ii) -- Taxes are nondischargeable if assessed less than 240 days prior to the filing of the bankruptcy petition (with this 240 days being extended for the period of time an offer in compromise is pending, plus 30 days).
A third important timing rule, applicable in Chapter 7 cases but not in Chapter 13, is found in BC §523(a)(1)(B):
523(a)(1)(B) -- Taxes are nondischargeable if the tax return was not filed, or was filed less than two years prior to the filing of the bankruptcy petition.24
Thus, as with so many things in life, timing is everything. Income tax debts which are nondischargable today may be dischargeable tomorrow. These timing rules can be the basis for the effective planning in preparing for the use of bankruptcy to obtain relief for a financially pressed taxpayer. But they also pose the threat of indefensible malpractice claims against those who fail to consider their impact. For example, the accountant or attorney who participates in the filing of a bankruptcy case for a client a week before his or her tax debts would have been dischargeable under the above-described rules may later find himself with both an unhappy client and a claim against his malpractice insurance policy. This is an area in which it pays to be very, very careful.
In addition to those income taxes made nondischargeable by the above-described timing rules, the Bankruptcy Code provides that certain specified kinds of taxes are nondischargeable regardless of when the petition is filed.
First, under BC §507(a)(8)(C), withholding tax liabilities are given a priority sufficient to make them nondischargeable. This covers a direct obligation for withholding taxes as well as indirect responsibility through the so-called "trust fund recovery penalty." Unfortunately, this rule denies relief to many taxpayers faced with truly unmanageable debts stemming from their involvement in failed businesses. Nevertheless, BC §507(a)(8)(C) is cruelly unambiguous on this subject, giving priority to "a tax required to be collected or withheld and for which the debtor is liable in any capacity." This same language also prevents the discharge of a liability for sales taxes which were collected, or which should have been collected, by the debtor.
Second, BC §523(a)(C) bars the discharge of debts, including tax debts, arising due to fraud:
(a) a discharge . . . does not discharge an individual debtor from any debt--
(1) for a tax or customs duty--
(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.
Note, however, that this rule does not apply to Chapter 13 cases, thus making it possible to discharge even taxes resulting from fraud if the taxpayer can meet the jurisdictional requirements of Chapter 13. The reason for the difference is that Chapter 13 discharges are granted under BC §1328(a), which protects only debts described in §523(a)(5)(8) and (9), and not those described in §523(a)(1)(C). This is the same reason that the "two year from date of filing" rule of §523(a)(1)(B) doesn't apply to Chapter 13 cases.25 These subtle but important statutory differences can be crucial in determining the appropriate kind of bankruptcy to be used in any given case.
Overriding all of these statutory timing issues is the question of "bad faith." The Bankruptcy Court is a court of equity, and can deny a debtor a discharge either in response to a motion from the IRS or sui sponte (i.e. on the Court's own initiative). This can occur when the Court is convinced that the debtor could pay at least a portion of the debts in question, but is instead inappropriately hiding behind the Bankruptcy Code and acting unjustly toward his or her creditors. For example, in In re Zuercher, 93 TNT 57-23 (Bankr. D. Hawaii 1993), the Court had little sympathy for a dentist with an "extravagant lifestyle" who had filed a previous bankruptcy case and took numerous actions designed to thwart his creditors. The Court denied the discharge, stating that "a person seeking relief under the Code must come in with clean hands, with an honorable purpose, and must be willing to use all of his resources to, at least, try to pay his creditors."
Fortunately, bad faith is most often raised by the IRS in cases involving tax protesters. Thus, in In re Paulson, 170 B.R. 496 (Bankr. D. Conn. 1994), the Court observed that "[a]ll courts . . . have concluded that the use of Chapter 13 by so-called tax protesters in an attempt to discharge their federal tax liabilities amounts to an unfair manipulation of the Bankruptcy Code."26 Similarly, several bankruptcy courts have held that the debtor's refusal to file income tax returns constitutes bad faith.27 Also, the fact that a bankruptcy is directed at a single creditor (such as the IRS) is often a factor in finding bad faith.28 Accordingly, before advising a client to seek relief from tax debts in bankruptcy, all the facts and circumstances must be carefully reviewed.
After the Discharge.
In the perfect case, upon entry of the discharge order the taxpayer would have no further obligations to the IRS, and would have thus achieved a complete fresh start. In the typical case, however, two problems often remain after the discharge. First, some taxes may survive the bankruptcy, and will therefore have to be addressed in the normal way. These might be taxes which were too new to be dischargeable, or which were of a kind not subject to discharge. And second, some dischargeable taxes may have been secured by liens. In this situation, while the client's personal liability for the taxes is discharged, the lien nevertheless continues as a valid encumbrance on the taxpayer's property. In other words, a distinction is drawn between the in personam liability, which is discharged, and the in rem claim against the assets covered by the lien, which survives.
Resolving Tax Problems Through Bankruptcy.
Having recited all of these complex rules, how does bankruptcy compare to other available approaches in securing relief from unmanageable tax debts? This is a fact-driven determination, and each case must be analyzed very carefully. There is no set answer which will be right in every case or for every client. All you can do is carefully assemble the facts and apply the relevant statutory rules to see where the client would come out under each approach. Nevertheless, some general observations can be made.
First, note that a Chapter 7 bankruptcy is a one-time, snapshot event. It looks at the debtor's assets and liabilities, and provides a fresh start by wiping out all dischargeable debts which exceed the value of the nonexempt assets. Hence, anticipated future income has no bearing on the matter, and no future monthly payments are required. By contrast, in an offer in compromise future income is an important factor. A taxpayer's ability to make payments to the Service from future income figures directly into the amount which must be offered before the IRS will accept the compromise offer. And note that the portion of the offer amount representing the present value of the future ability to pay must typically be funded from some outside source -- often a loan or gift from a family member. In Chapter 7, there is no obligation to fund any payment to creditors in excess of the value of the nonexempt, unencumbered assets.
Second, sometimes there are significant differences in the way assets are treated in bankruptcy versus in an offer in compromise. For example, a taxpayer may be married and yet have a tax debt for which his spouse is not liable. This can occur when the taxpayer owes income taxes for years prior to the marriage, or for years for which separate returns were filed.29 For purposes of an offer in compromise, the amount offered typically must include at least 50% of the equity in tenants by the entireties property, even if only one spouse owes tax and the property is clearly beyond the Collection Division's reach! In bankruptcy, by contrast, if only one spouse files a petition, such jointly owned property can be exempted from the debtor's bankruptcy estate. Jointly held property can be administered by the trustee for the benefit of joint creditors, even where only one spouse files bankruptcy. However, where the debts in question are owed by only one spouse there are no joint debts, and hence the tenants by the entireties property is off the table. In such cases a bankruptcy can yield a much better result than might be available through an offer in compromise.
Third, while an offer in compromise may do the job with respect to a client's federal tax liabilities, people who are in trouble with the IRS often have many other debts as well -- large credit card balances, bank loans, state tax liabilities, and more. Obviously, the offer in compromise involves only the IRS, and does nothing to solve these other significant financial difficulties. In contrast, a Chapter 7 bankruptcy addresses all of the debtor's liabilities, and therefore may be a much better choice for providing the "fresh start" the client needs.
On the other hand, some cases involve tax debts which are partially or entirely nondischargeable -- either because they are too "new" to meet one or more of the three time-related tests described above, or because the taxes are of a type not subject to discharge regardless of timing, e.g. withholding taxes or trust fund liabilities. In these cases, an offer in compromise might provide more relief to the taxpayer than would be available from a bankruptcy.
Finally, in most cases it is not a question of which single approach produces the best result on its own, but rather which combination of devices can be brought to bear on the taxpayer's problems and in what order. For example, often clients have to wait out the passage of the §507(a)(8)(A) and 523(a)(1)(B) time periods, and therefore will have to enter into installment agreements to make orderly and regular payments against their tax debts for some period of months or years to avoid the pain and suffering of IRS levy and distraint action. In other cases, the various dischargeability dates work out such that the client can at least try an offer in compromise while waiting for the taxes to lose their priority status. If the compromise is accepted, it can be used to solve the tax problem. But if it is rejected, the client can then use bankruptcy to discharge the liabilities.
In addition to combining bankruptcy with administrative remedies like installment agreements and/or offers in compromise, it is also possible to combine bankruptcies. Most notably, under present law it is possible to use a Chapter 13 in combination with a Chapter 7 -- described by some wags as a "Chapter 20." The approach is as follows: The Chapter 7 is first used to strip off those debts (including tax debts) which are subject to discharge in that case. Then a Chapter 13 is used to either discharge the remaining debts or to provide a vehicle through which they can be satisfied by monthly payments, free of late payment penalties and the threat of enforced IRS collection action. As noted above, Chapter 13 has jurisdictional limits which may make it unavailable to some debtors -- a maximum of $269,250 of unsecured debts and $807,750 of secured debts. There are no such limitations in Chapter 7. But under the right circumstances, sometimes the Chapter 7 can strip down the debts so that those which survive are small enough for the debtor to fit within the Chapter 13 limitations. Obviously, this is a very complex technique requiring both extremely careful planning based on a full understanding of the facts, and a long process of implementation before the desired results are achieved. In certain circumstances, however, the "Chapter 20" approach can provide relief for taxpayers who could have solved their problems in no other way.
In combining these bankruptcy and nonbankruptcy techniques, it is important to note that they have interesting and complex effects on one another. In particular, the above-described §507(a)(8) and §523(a)(1) time periods are in some cases extended. One such effect was mentioned above -- specifically, while §507(a)(8) requires that the taxes have been assessed for 240 days before the filing of the bankruptcy petition, the running of this 240 day period is suspended for the time an offer in compromise is pending, plus 30 days. Furthermore, all three of the statutory time periods are extended for the time any prior bankruptcy case was open, plus six months.30 These extension rules can make the determination of the relevant bankruptcy priority dates very tricky indeed.
Of all the techniques addressed by this series of articles on dealing with the IRS Collection Division, using bankruptcy to resolve tax liabilities is by far the most complex. It should not be approached without consulting specialists thoroughly familiar with the relevant issues. However, in the appropriate circumstances and after proper planning, bankruptcy can provide relief which is simply not available in any other way, and can enable financially strapped clients to put their problems behind them and start over. It is not for everyone, but for some it can produce miraculous results.
- Mr. Haynes is a tax lawyer in Burke, Virginia. From 1973 to 1981 he served as a Special Agent with the IRS Criminal Investigation Division, and in 1980 was named "Criminal Investigator of the Year" by the Association of Federal Investigators. He specializes in civil and criminal tax disputes and litigation, and the tax aspects of bankruptcy and divorce.
- Bankruptcy in general, and the impact of bankruptcy on taxes in particular, are exceedingly complex matters. This article will necessarily present only broad outlines of concepts and rules which are laced with exceptions and caveats. Before any bankruptcy is filed, extensive consultation with an experienced and knowledgeable bankruptcy practitioner is absolutely essential.
- In this article we will focus on individual taxpayers, although bankruptcy can also be extremely useful to business entities.
- Although an individual may file for reorganization under Chapter 11, this is a more complicated and expensive procedure usually appropriate only for business entities.
- Often these statutory exemptions are sufficient to protect most or even all of a debtor's assets. Thus, many Chapter 7 filings are for what are called "no asset" cases. And the "sale" of the assets is often back to the debtor himself for a price negotiated between the debtor and the trustee.
- See BC §109(e). The above amounts are effective for cases filed after March 31, 1998, and are indexed for inflation as required by BC §104(b).
- See BC §1326.
- See BC §1322(a)(2).
- See BC §1328(a). See also §1328(b) for a "hardship discharge" where the debtor is unable to complete the monthly payments required under the Chapter 13 plan.
- See IRC §1398(e)(2) and BC §541(a). See also IRS Pub. 908 "Bankruptcy Tax Guide."
- IRC §1398(e).
- See IRC §1398(g) and BC §346(i)(1).
- See IRC §1398(j)(2).
- See IRC §1398(i) and Regs. §1.1398-1(e) et seq. Note also that these tax attributes are reduced to the extent of the debts discharged. See IRC §108(b). This reduction in tax attributes occurs on the first day of the taxable year following the year of the discharge, thus giving rise to interesting planning opportunities. The attribute reductions are reflected on IRS Form 982, filed with the taxpayer's return for the year of the discharge.
- See IRC §1398(d)(1).
- See IRC §1398(d)(2).
- See Regs. §301.9100-14T(e).
- See Regs. §301.9100-14T(d) and (g).
- If assets are seized by the IRS before the filing of the petition, but haven't yet been sold, the trustee can demand that they be surrendered to the estate for the benefit of the creditors if "adequate security" can be provided. See U.S. v. Whiting Pools, 462 U.S. 198 (1983). This "turnover" power can be extremely useful if the IRS has seized assets necessary for the operation of the taxpayer's business.
- One commentator notes that IRS "is a frequent violator of the automatic stay provisions of the bankruptcy code" and "[d]ue to an uncooperative computer, the IRS has not adequately controlled enforcement actions against tax debtors, a shortcoming that has resulted in numerous 'opportunities' for the IRS to appear before the bankruptcy courts to try and explain its repeated violations. . ." Matthew J. Fischer, The Equal Access to Justice Act -- Are the Bankruptcy Courts Less Equal than Others?, 92 Mich.L.Rev. 2248, 2250-51 (1994).
- See IRS Restructuring and Reform Act §3102(c). See also IRS Announcement 98-89 (1998-40 I.R.B. 11) describing a pilot program to (1) streamline the handling of bankruptcy cases, (2) avoid inadvertent violations of the automatic stay, and (3) resolve taxpayer claims for damages resulting from IRS violations.
- See IRM 34(10)00, IRM 64(40)0 and IRM 57(13)1.
- See BC §506.
- A "substitute for return" prepared by the IRS as the basis for an assessment in the absence of a filed return does not constitute the filing of a return for purposes of BC §523. See e.g. In re Gushue, 126 Bankr. 202 (Bankr. E.D. Pa. 1991).
- Note that these §523(a)(1) issues do prevent the discharge of such taxes in Chapter 13 "hardship discharges" granted under BC §1328(b) when the debtor is unable to complete the payments provided for in the Chapter 13 plan.
- See also In re Love, 957 F.2d 1350, 1359 (7th Cir. 1992), noting that "filing a Chapter 13 petition in order to thwart the payment of an otherwise nondischargeable income tax debt arising from the unlawful failure to pay income taxes was not one of the intended purposes of the bankruptcy provisions."
- See e.g. In re Crayton, 169 B.R. 243, 245 (Bankr. S.D. Ga. 1994), holding that failure to file tax returns is the "epitome of a lack of good faith on the part of Debtor and demands dismissal".
- See In re Hammonds, 139 Bankr. 535 (Bankr. D. Col. 1992); In re Brown, 88 Bankr. 280 (Bankr. D. Haw. 1988).
- Whether married persons should file "married filing jointly" or "married filing separately" is an important decision requiring far more thought and analysis than it usually receives.
- In re Brickley, 70 B.R. 113 (Bankr. 9th Cir. 1986), In re Molina, 99 B.R. 792 (Bankr. S.D. Ohio 1988); In re Deitz, 116 B.R. 792 (Bankr. D. Colo. 1990); In re Quinlan, 107 B.R. 300 (Bankr. D. Colo. 1989).
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