First Published in the California Tax Lawyer
Many individuals, including accountants and lawyers, are under the misconception that taxes are not dischargeable in bankruptcy. Nothing could be further from the truth. Although there are a number of technical rules which can trap the unwary, most tax liabilities are dischargeable. This article explains the basic rules applicable to individuals, and also sets forth some of the tactical advantages of filing for bankruptcy. The law is constantly changing, and no article can take the place of competent legal counsel. Therefore if you are considering filing for bankruptcy you should not rely on this article, but instead consult a knowledgeable attorney.
There are two basic types of bankruptcy available to the average individual: liquidation under Chapter 7 and wage earner plans under Chapter 13.1 In Chapter 7, all of the taxpayer's assets and liabilities are marshaled. All of his assets, except for certain "exempt" assets are liquidated and paid to creditors in the order specified by the Bankruptcy Code. To the extent non-exempt assets are insufficient to pay all creditors, most of the unpaid debts are forgiven; i.e., they are discharged.
Generally, all income taxes, both Federal and state may be discharged if they are old enough. In the case of income taxes, they are dischargeable in Chapter 7 if all of the following criteria are met:
1. The tax is for a year for which a tax return is last due more than three years prior to the filing of the bankruptcy petition;
2. A tax return was filed more than two years prior to the filing of the bankruptcy petition;
3. The tax was assessed more than 240 days prior to the filing of the bankruptcy petition;
4. The tax was not due to a fraudulent tax return, nor did the taxpayer attempt to evade or defeat the tax;
5. The tax was not assessable at the time of the filing of the bankruptcy petition; and
6. The tax was unsecured.
Each of these requirements needs some explanation. Under requirement 1, a tax return's due date is determined taking into account all extensions. Thus, if a calendar year taxpayer obtained an automatic extension for 1988, the last due date of the return would be August 15, 1989, and a bankruptcy petition filed prior to August 15, 1992, would not result in a discharge of 1988 taxes. This would be true even though the tax return was actually filed prior to the extended due date.
Under requirement 2, the return must actually be filed more than two years prior to bankruptcy. If a return was never filed the tax is not dischargeable. Problems may arise if a taxpayer fails to file a tax return, and the Internal Revenue Service issues a statutory notice of deficiency. Once the 90-day period after the issuance of the notice of deficiency expires, the IRS will begin collecting the tax. However, since no return was ever filed the tax is nondischargeable. A possible solution is to file a tax return even though the Internal Revenue Service has already assessed the tax. This will begin the running of the two-year period required by the Bankruptcy Code.
Pursuant to requirement 3, the tax must be "assessed" more than 240 days prior to filing for bankruptcy. The word "assessed" is a term of art. A tax is assessed on the date the Internal Revenue Service assessment officer signs the summary record of assessment officially entering a tax liability on the Service's books and records.2 It is not the date the taxpayer files his tax return.
Usually any tax shown on a return is assessed shortly after the filing of the tax return. Tax deficiencies arising out of audits are assessed after the audit is concluded. It is not unusual, however, for there to be a delay of months, or even a year or more, from the time a taxpayer is notified that his audit is completed until the assessment is actually made. It is therefore imperative that a record of assessment be obtained from the Internal Revenue Service prior to the filing of a bankruptcy petition to ensure that the 240 day period has expired.
To illustrate, assume that a timely tax return for 1986 was filed. On May 15, 1991, the Service assessed an additional tax of $50,000. The tax will not be dischargeable if a bankruptcy petition is filed prior to January 11, 1992.
The 240 days is extended for any period during which an offer in compromise is pending with the IRS, plus 30 days. This extension does not apply unless the offer was made within 240 days after assessment. To continue the preceding example, if the taxpayer files an offer in compromise with the IRS on June 1, 1991, and it is rejected on August 1, 1991, then a Bankruptcy petition filed prior to April 11, 1992, would not result in a discharge. If, however, the offer in compromise was not filed until January 12, 1992, then it would have no effect on the 240 day period.
Requirement number 4 is self-explanatory. In order to assert the 75% fraud penalty, the burden of proof is on the IRS to prove fraud by clear and convincing evidence. However, to prevent the discharge of a tax liability, the IRS must only prove fraud by a preponderance of the evidence. This is a lesser standard of proof than that required to assert the fraud penalty. Thus, the IRS could assert the fraud penalty in Tax Court and lose, but in a bankruptcy discharge hearing the IRS could prevail on the fraud question, with the result that the tax would be nondischargeable.
Under requirement 5, if a tax is still assessable at the time of the bankruptcy it is not dischargeable. Therefore, if the taxpayer has signed Form 872 or 872A extending the statute of limitations, the Internal Revenue Service can assess an additional tax after bankruptcy, and the tax will not have been discharged. This problem is especially pernicious in the tax shelter area. Often the Service obtains a waiver of the statute of limitations on assessment which is effective until canceled by either the Internal Revenue Service or the taxpayer. Once the waiver is signed, it may take as long as five or ten years for a case to wind its way through the IRS bureaucracy, and then through the courts. A taxpayer can file a bankruptcy petition, thinking that the problem with the IRS was already resolved, only to discover too late that the additional tax has survived the bankruptcy filing.
This problem is exacerbated where the taxpayer has invested in a partnership subject to the TEFRA audit rules. Generally, these are partnerships with taxable years beginning after September 2, 1982, and which have more than 10 partners. In such partnerships, the tax matters partner may extend the period for assessing tax for all the limited partners, and he may have done so without notifying the limited partners.
While unsecured taxes meeting requirements 1 through 5 are dischargeable in a Chapter 7 bankruptcy, taxes which are secured by a federal tax lien survive the bankruptcy. A federal tax lien arises upon the assessment of the tax.3 For bankruptcy purposes, however, a tax is not considered to be secured unless a valid federal tax lien has been filed by the IRS prior to bankruptcy. In order for the lien to be valid, it must be filed with the appropriate state office as designated by state law. Thus, for example, in California, for a lien to be valid as to real property, it must be recorded with the County Recorder for the county in which the property is situated.
Since the federal tax lien attaches to all property and rights to property of the taxpayer, it is virtually certain that some portion of the debt to the Internal Revenue Service is secured. In many cases, however, only a portion of the tax is secured because the liability exceeds that value of the property.
To illustrate, assume that a taxpayer has a tax liability of $50,000 which is otherwise dischargeable. If he owns as his only property raw land worth $15,000 which is security for a bank loan of $17,000, the taxes are completely unsecured because he has no equity in the property to which the IRS lien will attach. On the other hand, if the property is worth $25,000, then the IRS lien attaches to the equity of $8,000. The tax liability is considered to consist of two debts, a secured debt for $8,000 and an unsecured debt for $42,000. The unsecured debt will be discharged, assuming it meets requirements 1 through 5, while the secured debt may still be collected by the IRS by seizing and selling the land.
A problem arises if the property appreciates in value after the bankruptcy petition is filed, but before the IRS takes action to sell the property. In the above example, assume that a year after the bankruptcy case is closed the Internal Revenue Service seizes the taxpayer's property, which has now appreciated in value to $35,000. The Internal Revenue Service will be able to successfully argue that it is now secured to the extent of $18,000 ($35,000 less bank loan of $18,000).4 Therefore, it is probably best to sell the property, and use the proceeds to pay the secured debt to the IRS.5 As long as the debt was otherwise dischargeable, the taxpayer can purchase new property which will be unencumbered by the IRS lien.
A related problem is exempt property. In Chapter 7, although most of the debtor's property is sold to pay his debts, he is allowed to retain certain assets. These are referred to as exempt property. The amount and types of property which are exempt vary from state to state. In California, for example, included in a taxpayer's exempt property is the equity in his home, up to $50,000 for a single person. After the bankruptcy case is closed, creditors are generally not allowed to seize exempt property to satisfy pre-bankruptcy debts. The IRS is an exception to the general rule, however, since it may collect nondischargeable taxes from exempt property.
Up to this point the discussion has been limited to the dischargeability of taxes, with no mention of interest and penalties. By the time a tax is old enough to be eligible for discharge, it will have accrued interest and penalties which may exceed the amount of the actual tax. The question of whether these penalties and interest are dischargeable is, therefore, of crucial interest to the taxpayer. Generally, the courts have held that if a tax liability is dischargeable, the interest on it is also dischargeable.6 Conversely, if the tax is nondischargeable, so is the interest.
Penalties are a different matter. Only "non-pecuniary loss penalties" are dischargeable. These are penalties which are not meant to compensate the government for actual pecuniary loss, but instead are punitive. Examples are the negligence, fraud, and accuracy-related penalties. An example of a pecuniary loss penalty is the "trust fund recovery penalty" imposed by IRC Section 6672, which is designed to recover income and FICA taxes withheld from wages paid to corporate employees. The trust fund recovery penalty, since it is meant to compensate the government for unpaid payroll taxes, is not dischargeable.7 A pecuniary loss penalty will be treated like the tax itself, and may be dischargeable.8
Usually, the dischargeability of a tax penalty that is punitive follows the dischargeability of the tax. However, three Circuit Courts of Appeal have held that tax penalties related to tax periods more than three years prior to the filing of the petition are dischargeable, even though the tax is not. Thus, a fraud penalty has been held to be dischargeable, even though the tax which had been fraudulently avoided was not.9 On the other hand, a fourth circuit has held to the contrary.10
Debtors seeking shelter from the Internal Revenue Service are not limited to the protections of Chapter 7. They may also file for bankruptcy under Chapter 13 or Chapter 11. While Chapter 7 involves a liquidation of the debtor's assets and liabilities, Chapter 13 is a reorganization of the debtor's financial affairs with an opportunity to pay all or a portion of his debts over a period of time. One of the advantages of Chapter 13 is the ability of the debtor to retain his assets while paying his creditors out of current income over a period of years. This is one method of dealing with an IRS Revenue Officer who insists on an unreasonable installment arrangement, or who threatens to levy on the taxpayer's assets.
Chapter 13 used to be referred to as a wage earner plan because only wage earners could file under Chapter 13. In 1978 Congress expanded Chapter 13 to include any individual with regular income. This includes not only self-employed individuals, but even those whose income is limited to pension or public assistance payments. As long as the income is sufficiently consistent to permit regular payments to creditors to be made, Chapter 13 will be available.
Another limitation on Chapter 13 is that the total amount of the debtor's secured liabilities to all creditors cannot exceed $809,750 and his unsecured liabilities cannot exceed $269,250. In determining the amount of a debtor's liability, the courts have been unable to agree upon the treatment of a disputed liability. Some courts have measured the amount of the liability by the debtor's good faith estimate of the debt, others by the amount of the creditor's claim.11
Under Chapter 13, a debtor must propose a plan to repay his creditors within three years. The Bankruptcy Court may, however, allow a payment plan to extend for a period of up to five years. Although there is no requirement that a Chapter 13 debtor repay all his creditors, he must pay all his priority debts in full. Priority debts include income tax liabilities which are nondischargeable in a Chapter 7 bankruptcy because they meet either of the following criteria:
1. The tax is for a year for which a tax return is last due three years or less prior to the filing of the bankruptcy petition; or
2. The tax was assessed less than 240 days prior to the filing of the bankruptcy petition.
Thus, even though the taxpayer has filed a fraudulent tax return or otherwise willfully evaded taxes, the tax, penalty and interest may be dischargeable provided that the liability is not a priority debt. Taxes for which no return has been filed, or for which a return has been filed within the previous two years, are also dischargeable in Chapter 13, even though they are not dischargeable in Chapter 7. Another advantage of Chapter 13 is that it can be filed even though the taxpayer has previously received a discharge in Chapter 7, whereas a debtor must wait six years between the filing of Chapter 7 bankruptcies.
Furthermore, Internal Revenue Code Section 6658 provides that late payment penalties do not accrue during the pendency of a bankruptcy case.12 While a Chapter 7 case generally lasts about six months, a Chapter 13 case can be open for five years; therefore, this provision has a greater effect on Chapter 13 cases than Chapter 7 cases.
This article has focused on the reduction or elimination of tax liabilities which the taxpayer acknowledges are owed. However, if the taxpayer disputes the amount of the tax owed, the Bankruptcy Court is an excellent forum for obtaining a judicial determination of the amount of the liability. This is especially so in situations where the taxpayer cannot obtain access to the more common methods of court review.
For example, a taxpayer who receives a 90 day letter, but fails to file a timely petition with the United States Tax Court, must pay the tax in full before he can file suit in either District Court or Claims Court to obtain an adjudication of whether the amount was actually owed. In Bankruptcy Court, however, there is no requirement that any payment be made prior to a determination of the amount due. Furthermore, during the pendency of the bankruptcy, the IRS cannot pursue collection due to the automatic stay.
While bankruptcy may still retain a certain stigma, in appropriate cases the financial benefits may be too great to ignore.
|1.||Reorganization under Chapter 11 is also a possibility; however, discussion of that subject is beyond the scope of this article.|
|2.||Treas. Reg. §301.6203-1.|
|3.||Internal Revenue Code §6621.|
|4.||In re Phillips, 197 B.R. 363 (MD FL 1996); See Dewsnup v. Timm, 112 S. Ct. 773 (1992)|
|5.||Lien stripping is probably permissible in Chapter 13. See In re Dever, 164 B.R. 132 (Bankr. C.D. CA 1994).|
|6.||Matter of Larson, 862 F.2d 112 (7th Cir. 1988).|
|7.||United States v. Sotelo, 436 U.S. 268 (1978).|
|8.||Hanna v. United States, 872 F.2d 829 (8th Cir. 1989).|
|9.||In re Burns, 887 F.2d 1541 (11th Cir. 1989); McKay v. United States, 957 F.2d 689 (9th Cir. 1992); In re Roberts, 906 F.2d 1440 (1990).|
|10.||Cassidy v. Commissioner, 814 F.2d 477 (7th Cir. 1987)|
|11.||Cf. In re Lambert, 43 B.R. 913 (Bankr. D. Utah 1984), with In re Sylvester, 19 B.R. 671 (9th Cir. BAP 1982).|
|12.||This rule does not, however, apply to the trust fund recovery penalty.|
*Dennis Brager, Esq., is a State Bar Certified Tax Specialist in Los Angeles. A former IRS senior trial attorney, Mr. Brager now devotes his efforts exclusively to helping clients resolve their tax problems with the IRS and California State tax agencies. Services include negotiating Tax Debts, Tax Fraud Representation, Tax Litigation, Tax Audit and Appeals Representation, Tax Preparer Penalty Mitigation, Payroll Tax Audits, and California Sales Tax Problems. He may be reached at 800.380.TAX LITIGATOR.
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