The Impact of the New Bankruptcy Law on Tax Debtors: A First Impression

Background

Under current law income taxes are generally dischargeable in a Chapter 7 proceeding if all of the following three rules are met:

  1. The bankruptcy is filed more than 3 years after a return is due (including extensions). See Bankruptcy Code §507(a)(8)(A)(I);
  2. The bankruptcy is filed more than 2 years after a return is actually filed.  Bankruptcy Code §523(a)(1)(B); and
  3. The bankruptcy is filed more than 240 days after the assessment is made. See Bankruptcy Code §507(a)(8)(A)(ii). The 240 days is extended by any period during which an offer in compromise is pending + 30 days. Id.
The Changes

The vast bulk of the provisions of the  "Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 signed by President Bush on April 20, 2005 are effective on Monday October 17, 2005.  Debtors who were on extension until October 15 for the 2001 tax year and want to discharge income tax liabilities for that year must file for bankruptcy after October 15, 2005. Thus, a debtor who wants to both file under the old law, and discharge their 2001 income tax liability must file on Sunday, October 16, 2005.  Luckily, with the wonders of electronic filing this should be possible.

The good news is that the most feared provision of the new law, so-called "means testing," probably doesn't apply to tax driven bankruptcies.  As amended, Bankruptcy Code § 707(b), will allow the dismissal of a Chapter 7 case "upon a finding of abuse by an individual debtor with "primarily consumer debts." The Trustee or any creditor can bring a motion to dismiss under §707(b) if the debtor's income is greater than the state median income.

Various amounts are being reported as California's median income, but from what we have been able to determine so far the amount is between approximately $52,000 and $63,000, depending upon the size of the family. It is expected that the U.S. Trustee's office will publish tables from which these amounts can be determined.  If a debtor's income falls below the state median, the court may still find abuse but the creditors do not have the standing to file the motion. Bankruptcy Code § 707(b)(2)(A).

Abuse is presumed if the debtor's currently monthly income (as determined by an average of the previous 6 months) less secured payments divided by 60, less priority debts divided by 60, less the allowed expenses permitted by the IRS allowable standards, less certain other allowed expenses, is greater than $100 per month.  The presumption of abuse may only be rebutted by demonstrating "special circumstances" that justify additional expenses or adjustments of current monthly income. Bankruptcy Code § 707(b)(2)(B).

As noted above, the presumption of abuse only applies to debtors with primarily consumer debts.  The phrase consumer debt is not new, and continues to be defined in Bankruptcy Code § 101(8) as debt incurred "primarily for personal, family or household purposes."  The 6th Circuit Court of Appeals has ruled that taxes are not consumer debt. In re Westberry, 215 F.3d 589, 593 (6th Cir. 2000).  Indeed the majority of the courts that have looked at the issue have ruled the same way. See In re Brashers, 216 B.R. 59, 60 (Bankr. D. OK., 1998).  Of course there is no guarantee that down the road these cases might not be overruled so caution is advised in advising clients how to proceed.

Bankruptcy Code § 507(a)(8)(A)(ii)(II) is  amended to extend the 240 day look-back period for taxes by:  "any time during which a stay of proceedings  against collections was in effect in a prior [bankruptcy] case . . . during that 240-day period, plus 90 days"; and  "any period during which a governmental unit is prohibited under the applicable nonbankruptcy law from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days . . . ." Thus the 240 day period will be extended if a taxpayer files a collection due process appeal from a notice of intent to levy.  Of course it could be argued that the IRS is not prohibited from collection by a CDP appeal, it is merely prohibited from levying. The IRS could for example bring suit to recover the tax due.

Interestingly, neither the two or three year look-back periods are tolled by the filing of a CDP appeal, nor indeed a prior bankruptcy. Of course, in Young v. United States, 535 U.S. 43 (2002) the Supreme Court held that the 3 year look back period was tolled during the pendency of a prior bankruptcy. One could argue that new Bankruptcy Code § 507(a)(8) overrules Young.

Bankruptcy Code § 507(a)(8)'s existing tolling of the 240-day period following assessment of a tax (by the time during which  pendency of an offer in compromise is pending during that 240-day period, plus 30 days) is restated, but does not appear to have been changed.1

Another very significant change impacting tax debtors is that it will no longer be possible to discharge taxes from fraudulent returns in a Chapter 13 proceeding, nor taxes for which a return was not filed. See Bankruptcy Code § 1328(a)(2).

There are other changes buried in the new Act, but like the title says these are my "first impressions."

ENDNOTES

1 Cf. current 11U.S.C. § 507(a)(8)(ii) with 11U.S.C. § 507(a)(8)(ii)(I)  effective Oct. 17, 2005.


*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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