Dealing with Tax Issues in Bankruptcy
By Gary Bluestein
The issues created by the intersection of bankruptcy law and tax law are exceedingly complex and full of pitfalls for the unwary practitioner. Unfortunately for lawyers practicing in only one of these two areas, it often is impossible to avoid the overlap of these specialties. From the bankruptcy practitioner’s perspective, the taxing authorities are both common and aggressive creditors and unanticipated tax issues often arise. Form a tax practitioner’s perspective, bankruptcy is often an extremely valuable tool in solving a tax problem and a tax representative not well versed in the benefits of bankruptcy may not be giving their clients complete representation.
There are many nuances that are beyond the scope of this presentation. These involve statutory provisions contained in the Internal Revenue Code that directly impact bankruptcy. Important examples would be 26 U.S.C. §108 and §1398. The former deals with impact of bankruptcy and insolvency on debt forgiveness income, and the latter deals with the creation of a separate taxable estate in an individual Chapter 7 or 11. Both provisions may have significant impact on a consumer bankruptcy, and although beyond the scope of this discussion, it may be useful for bankruptcy lawyers to review these provisions.
The main focus of this discussion is the basics of dealing with tax claims in bankruptcy and when they can be discharged.
Types of Pre-Petition Tax Claims
Secured Tax Claims
In order for the IRS to have a secured status in a bankruptcy, two requirements must be met:
There must be a pre-petition Notice of Federal Tax Lien filed (NFTL), and
There must be equity in property for the lien to attach.
Note: A federal tax lien attaches to all property, both real and personal.
Note: There are no exemptions to a federal tax lien.
A filed lien can be devastating for a debtor.
Example 1: A taxpayer with exempt property- If the taxes in questions would not qualify as “priority” (explained below) and the debtor has an asset that would be exempt in bankruptcy (i.e. an IRA), even though the exemptions don’t apply against the IRS, the asset would be exempted from the bankruptcy estate. The taxes would then be discharged and the debtor would keep the exempt asset after bankruptcy.
But- same facts, except NFTL filed pre-BK, although underlying tax is discharged, the lien would stay on the exempt asset. The IRS would then be able to take collection action against the asset, up to the value at the time of the petition, after the stay on collection was lifted.
Example 2: If NFTL is filed and the IRS is secured, older non-priority taxes and penalties would be secured. The IRS will treat the oldest periods as secured. If, for example, a debtor owed taxes for the years 2003 ($25,000), 2004 ($25,000) and 2005 ($50,000) and the debtor had an asset worth $50,000, even if the 2003 and 2004 were otherwise dischargeable, they would be treated as secured. The 2005 would not be dischargeable (see discussion below). Therefore, in a Chapter 7 context, the $50,000 would be applied towards the 2003 and 2004 years as a secured claim and the 2005 year would not be dischargeable and would survive bankruptcy. In a Chapter 13 context, the 2003 and 2004 would be fully paid as secured and the 2005 would be fully paid as priority. In both scenarios, the debtor would pay a total of $100,000, rather than $50,000 if no NFTL was filed.
Solution: Pre-Bankruptcy Strategy- Liquidate $50,000 asset and pay it with a designation to the 2005 tax year, then file bankruptcy.
Key Practice Point: Whenever a voluntary payment is made to the Internal Revenue Service, the payment can be designated by indicating how the tax should be applied on the front and back of the check. Failure to designate will allow the IRS to apply the payment to the best interest of the government. The IRS will always apply to the oldest period first.
Note: This is also extremely important when dealing with a payroll tax liability. Since a payroll tax liability for a corporation is made up of a non-trust fund portion and a trust fund portion, the latter being a potential personal liability of an individual associated with the corporation, voluntary payments out of the corporation should always be designated to trust fund taxes.
Priority Tax Claims
Bankruptcy Code §507(a)(8) provides for priority status in relation to certain taxes. Whether a tax qualifies as “priority” under this section is of critical importance to the debtor. It not only determines the order in which the taxes will be paid out of assets that are being distributed in a Chapter 7, but more importantly to the debtor, priority taxes are not dischargeable in a Chapter 7. Moreover, a Chapter 13 and Chapter 11 plan cannot be confirmed without providing for full payment.
Trust fund taxes are always granted priority status pursuant to §507(a)(8)(C ). This not only includes taxes that were required to be withheld in relation to payroll taxes, but will also include state sales tax.
In relation to income tax, however, unlike the trust fund taxes mentioned above, timing may play a critical role in determining whether or not the taxes qualify as priority. Bankruptcy Code §507(a)(8)(A) sets forth the type of tax that qualifies as priority as follows:
- A tax on or measured by income or gross receipts for a taxable year ending on or before the date of filing of the petition-for which a return, if required, is last due, including extensions, after three years before the date of filing of the petition;
- assessed within 240 days before the day of filing of the petition exclusive of –
- anytime during which an offer in compromise with respect to that tax was pending or in effect during the 240 – day period, plus 30 days, and
- anytime during which a stay of proceedings against collection was in effect in a prior case under this title during that 240 day period, plus 90 days.
An otherwise applicable time period specified in this paragraph shall be suspended for any period during which a governmental unit is prohibited under applicable non-bankruptcy law from collecting a tax as a result of request of the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days, plus anytime during which the stay of proceedings was in effect in a prior case under this title or during which collection was precluded by existence of one or more confirmed plans under this title, plus 90 days.
Other than a tax of a kind specified in §523(a)(1)(B) or §523(a)(1)(C ) of this title, not assessed before but assessable, under applicable law or by agreement, after, the commencement of the case.
Specifically addressing dischargeability, §523(a) provides an exception to discharge for the following:
- Priority taxes (explained above)
- Taxes relating to delinquent returns filed within two years of bankruptcy.
- Taxes relating to unfiled returns.
- Fraud or willful attempt to evade or defeat a tax.
Note: The above provisions apply to both Federal and State taxes.
It is clear from the above cited statutory provisions, that in dealing with income taxes, mistiming a bankruptcy is a huge pitfall and potential for a malpractice action. The priority sections of 507 provide for bright line timing issues that an unwary practitioner could easily miss. §523 also provides for a timing issue in relation to a delinquent return.
Note: Interest is considered part of the tax. Therefore, if the tax qualifies as “priority”, so does the interest thereon. With regards to penalties for dischargeability in a Chapter 7 or individual 11, pursuant to §523(a)(7), generally the three year rule applies. Chapter 13 allows for the dischargeability of penalties.
Taxes and the interest thereon, as well as penalties, that do not qualify as secured or priority fall into the general unsecured category. These liabilities are dischargeable in a Chapter 7 and can be paid in the same manner as other unsecured creditors in a Chapter 13 and a Chapter 11.
Review of Key Points to Dischargeability
- Was the return, plus extensions, due within three years?
- Was the tax assessed within 240 days; was an OIC filed during that time period?
- If the tax is not assessed, is it still legally assessable?
- Was a prior bankruptcy filed?
- Was a Collection Due Process Appeal filed?
- Was the return filed?- SFRs don’t count.
- If the return was delinquent, was it more than two years ago?
- Was there fraud or willful attempt to evade tax?
- Was a Federal Tax Lien filed prior to bankruptcy, and if so, is there equity in any assets for it to attach?
Section 507(a)(8) and Section 523(a) Examples
Income taxes 2000-2002, returns timely filed, no fraud, all taxes assessed prior to February 2005.
Income tax 2000 assessed per audit 2001, fraud penalty.
Income tax liability 2000, not assessed but still assessable, case pending in the U.S. Tax Court for several years.
Income tax 2002, audit, 40% omission of income, not yet assessed.
Income tax 2000, no filed returned.
Income tax 2001, return filed January 2, 2006, tax assessed January 15, 2006.
Client owes for trust fund tax for the 1st quarter of 2002, the tax was assessed April of 2002, 941 return was timely filed.
8. 2004 Return filed 10/15/05, on extension, assessed October 20th.
9. 2004 Return filed 10/15/05, not on extension, assessed October 20th.
10. 2003 Return filed 9/10/07, assessed 9/15/07.
11. 2003 Return not filed, SFR assessed 4/10/05.
12. 2004 return timely filed, 4/15/05. CDP filed 1/1/08. Rejected 2/1/08.
13. 2003 return filed 1/1/06. CDP filed 5/1/07, rejected 1/1/08.
14. 2003 Return filed 4/15/04. Audited, large liability assessed 5/10/06. OIC submitted 2/10/07, rejected 1/10/08.
The means test only applies to cases that are “predominantly consumer debt”. It is the consensus that taxes are not considered consumer debt.
Having a priority tax claim or a secured tax claim may assist an individual in satisfying the means test, since priority and secured claims must be paid in full in a Chapter 13.
Final Notice of Intent to Levy
Notice of Federal Tax Lien
Proof of Claim