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DISCHARGING TAXES IN
Disclaimer: Bankruptcy Reform is going to create a whole new set of case law over its provisions. We have attempted to predict in many cases the results of Reform on the discharge of taxes; however, there is no certainty what body of law will evolve from the new law. Please understand that this document is not to be relied on as a substitute for doing research or verifying what the case law has determined. This will provide an overview of the basics of bankruptcy discharge. It will attempt to explain in a simple and understandable manner as possible what is required in order in order for taxes to be discharged in bankruptcy. It is not intended to be a comprehensive discussion. To learn the nuances and become well versed in handling discharge of taxes in bankruptcy we would suggest that you obtain Morgan King’s outstanding book Discharging Taxes in Bankruptcy. In 1,000 pages or less he will tell you everything you always wanted to know about tax discharge. We refer to his book constantly. It comes complete with a thorough discussion, including case citations, to everything you could possibly imagine relating to the discharge of taxes in bankruptcy. It is important to learn the principles of tax discharge in bankruptcy if you represent clients with tax problems. There are several reasons to learn bankruptcy discharge. First, it may be that you client will fare far better in a bankruptcy than in some other type of relief from their tax liability. Second, you will be better able to advise your client if you know the principles of Bankruptcy Discharge. Third, knowing the principles may help you avoid a mistake that could result in a negligence action against you. Finally, knowing the rules of tax discharge in bankruptcy gives an attorney a definite advantage when negotiating with the Internal Revenue Service. For example, one of the criteria in the IRS employee’s manual is in considering an Offer in Compromise is "To determine what the effects of bankruptcy would be in analyzing the settlement potential of an Offer in Compromise". There have been numerous occasions, in our office where Offers in Compromise have been settled solely on the basis of a threat to file bankruptcy. A. REQUIREMENTS TO DISCHARGE TAXES IN CHAPTER 7 1. The tax must be over three years old from when the return first came due. For example, the year 2000 tax return became due on April 15, 2001. On April 16, 2004 the tax meets the requirement of being over three years old from the date it first became due. TRAP: You must ensure that your client did not file a Request for Extension of time to file their return. If your client filed a Request for Extension, that would extend the due date for the return and the start of the three year period. This is one of the major reasons why it is important to review a tax transcript before filing a bankruptcy on behalf of a client who has taxes that are between three and four years old. We have found that it is not wise to trust our clients when they tell us that they did not remember filing a Request For Extension. We have often found that clients who do not believe that they filed a Request For Extension did indeed file for an extension. We are talking about events that occurred three to four years previously and memories fail. 2. Two years since the tax since the tax return was filed. It must be at least two years since the tax return was filed in order to meet this element of dischargeability. There are numerous lines of cases which address what constitutes a tax return and whether or not it was filed. TRAP: If the Internal Revenue Service filed a Substitute For Return (SFR). This does not constitute the filing of a return and the taxes will not be dischargeable. There is a split of authority between the districts as to whether or not a tax return filed by the taxpayer after the Internal Revenue Service has filed an (SFR) qualifies. The Ninth Circuit, predictably, has held that a later filed return and good faith will allow the taxes to be discharged. Most Districts are not as liberal. It is uncertain whether this will still be the case after bk reform, but is appears that such a return will qualify. See 523(a)(1)(B)(ii) 3. Two hundred and forty days since the tax was assessed. When a taxpayer files a tax return the Internal Revenue Service usually assesses the tax within a relatively short time thereafter. This time period may be a few days or up to a couple of months. The tax does not become dischargeable in bankruptcy for two hundred and forty days after the tax has become assessed. Trap: Time spent in an Offer in Compromise or prior time in Bankruptcy plus 90 days tolls the 240 day assessment period. 507(a)(8)(A)(i&ii) 4. A review of the tax transcripts will show your clients history. We have found that these tax transcripts are generally accurate and may be relied upon to a certain degree. We always obtain tax transcripts when there are a significant amount of taxes involved. The transcript we order is called a MFTRA-X. It is written in plain English and readily understandable. 5. New Tolling periods: There are several new tolling periods which will extend the time period for discharge of taxes. They include any period the taxing authority is prohibited under applicable nonbankruptcy law from collecting a tax as a result of a request of the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days; plus any time during which the stay was in effect from a prior bankruptcy proceeding. 507(a)(8) B. PRINCIPLES OF CHAPTER 13 DISCHARGE Tax Discharge in Chapter 13 WAS far more flexible than a Chapter 7. It allowed for taxes to be discharged pursuant to the provisions of the "Super Discharge". It still allows a way for clients to payoff otherwise non-dischargeable taxes throughout the life of the chapter 13 plan yet still abate penalties and reduce interest to, at this current writing, 5% on secured claims. 1. Tax more than three years old. The requirements that the tax be more than three years old are virtually the same as in a Chapter 7 case. 2. Two Years since the Tax Return was filed. Under the former law, it was not required that it has been more than two years since the tax return had been filed. As noted below, taxes where the returns had not yet been filed as of the date of filing of the bankruptcy WERE still, in many cases, subject to discharge. Bankruptcy Reform has changed this! This is probably the greatest single change from the previous law. Now, the return must have been filed 2 years before the Bankruptcy was filed in both Chapter 13 and Chapter 7. 3. Two hundred forty days since assessment. It is required that the taxes owing be assessed at least two hundred forty days before the chapter 13 is filed. 4. Tolling Periods: The same tolling periods apply in Chapter 13 that are applicable to Chapter 7j C. TREATMENT OF TAXES IN CHAPTER 11 1. Taxes in Chapter 11 are treated very similar to treatment in Chapter 13, with certain exceptions. a. With regard to priority taxes, the Debtor in Possession has 5 years from the date of Confirmation to pay the Priority Taxes. This is an advantage over the prior law which allowed 6 years from the date of assessment. b. The DIP must pay interest on the Priority Taxes. c. Secured Taxes may be paid over a longer period of time. This depends on how long a time period set either through negotiations or by Court Order. D. TAX CLAIMS IN BANKRUPTCY The Internal Revenue Service in Chapter 11 and 13 cases will file a Proof of Claim breaking down their claim into Priority Claims, Secured Claims, and Unsecured General Claims. 1. Priority Taxes: Priority taxes are those taxes which do not meet the test for discharge. That is, they are:
Less than three years old, or; Payroll taxes, discussed infra, are also priority taxes. Priority Taxes must be paid in full through a Chapter 13 and they survive a Chapter 7 discharge. Their treatment in Chapter 13, is favorable to the Debtor, however. The tax and interest which has accrued up to the date of filing must be paid through the Chapter 13 plan. Penalties are not treated as priority taxes, however. They are treated as General Unsecured Claims. Priority taxes are paid through Chapter 13 without interest. Only the actual tax plus the interest that accrued up to the date of filing must be paid through the plan. This is very favorable treatment. 2. Secured Tax Claim: If the IRS has filed a valid tax lien, the taxes subject to the lien may be treated as secured. In Chapter 11 or 13, the secured portion of the claim is only up to the value of the Debtors property. It should be noted that the security for the claim includes ALL of the Debtors property, without any deduction for the exemptions which the Debtor may otherwise claim. This result means that there is a motivation in getting a Bankruptcy filed before a Tax Lien is filed. Be aware that the IRS may have filed Tax Liens for some periods, but not others. An early and careful review of the transcripts is necessary to decide when to file. A frequent occurrence arises in situations where you are waiting out one of the time periods to insure a particular tax becomes unsecured. The threat of a tax lien adds complications to the determination of when to file the Bankruptcy action. 3. Unsecured General Claims: This is the category that we try to fit as much of the tax as possible into. This category of tax is treated the same as any other general unsecured debt. That is, the IRS will receive its pro rata share of any dividend to unsecured creditors. 4. Payroll Taxes: The general rule is that Payroll taxes are trust fund taxes and are not subject to Bankruptcy Discharge. They are treated as priority taxes or secured if a tax lien has been filed. They must be paid through the Chapter 13 plan and are not subject to discharge in a Chapter 7. Priority Taxes do not receive interest on them, however. Penalties are treated as unsecured. This favorable treatment often allows a Chapter 11 or 13 plan to deal with the taxes on a favorable basis. 5. Sales Tax: If the sales tax is just that, a tax on the buyer, (it is in Idaho) generally it is treated as a tax which is subject to the same rules relating to Discharge as normal income tax. The general rule is that if the tax is imposed on the buyer or customer, then it is a trust fund tax and not subject to discharge. If imposed on the retailer, then in some states it is subject to discharge. 6. Liens and Chapter 7: The rule in Chapter 7, where the taxes owed exceed the value of the Debtor's property, that the lien may NOT be stripped down to the value of the debtors property. The lien survives Bankruptcy and even though the tax might have been discharged, the lien remains on the Debtor's property for its full amount. This creates a trap for the unwary. If a lien is not released, it remains and attaches to all of the debtors property. The issue may arise years later. An example of how onerous this can be arises where a client has real property, there is a tax lien and a Bankruptcy is filed. In that situation, if the lien is not released and the property appreciates, the lien creditor (the IRS or State Tax Authority) gains the benefit of the appreciation in the property value. This issue of liens is complicated when the Debtor has assets, particularly if the lien is for more than the value of the assets. In Chapter 7, the lien is not stripped down to the value of the collateral. The lien remains, for its full amount on the debtor's assets until it is released. (Dewsnup v. Timm 112 S.Ct. 773.) This creates a situation that can come back to haunt an attorney who files Bankruptcy for a client, then, months or even years later, the debtor discovers that there is a Tax Lien outstanding. This matter is further complicated if there are Judgments which have been avoided because they impair the Debtor's homestead exemption. In that situation, does the IRS move up in priority to take the place of the avoided judgment lien? In the Ninth Circuit it does not. Our office has developed a methodology to deal with Tax Liens in Chapter 7. First, we always order an IRS transcript to determine what liens have been filed, their amount and their validity. Second, we advise the client of the liens and the implications. Third we analyze the value of the debtors property. (Exemptions do not apply to tax liens). Then we develop a plan to deal with the lien. In our District, Bankruptcy Unit is who we deal with for liens after Chapter 7. They are well educated and reasonable to work with. Depending on the particular situation, that plan might include: 1. Challenge the validity of an invalid Tax Lien. We have found that there are circumstances where a Tax Lien avoidable or invalid. To avoid a lien, it must be improperly filed. Examples of an improperly filed lien are those where it is filed in the wrong county or is being asserted against after acquired real property, for taxes that were discharged. A more frequent occurrence is where the Tax Lien has been filed in the wrong name, such as a corporation rather than the debtor. In an case where the IRS had the first name spelled wrong, a Bankruptcy Court held the lien invalid. In Re Reid 182 B.R. 443 Other examples of an invalid lien are where the IRS failed to comply with state law or where they failed to refile after the 10 year life of the lien. It has also been held that a lien filed in violation of the automatic stay is invalid. Local practice will determine whether a lien may be challenged by motion or must be challenged by adversary complaint. 2. Requesting a Certificate of Release from the IRS. If the taxes have been discharged and the value of the debtors assets is minimal we will just request that the IRS release the lien. The IRS will usually release its lien. If some of the tax has been discharged, but not all, then the IRS will usually not release the lien. 3. Negotiate a release for an amount to be paid. We have found in our District that the IRS is usually willing to negotiate a favorable resolution of the amount it will settle for. The IRS simply doesn't want your clients furniture or old car. Even equity in a parcel of real estate may be negotiated for less than its real value. 4. Advise client to wait out the Statute of Limitations. The tax lien is valid for 10 years from the date the taxes were assessed (not 10 years from the date the lien was filed). If that period is close to running we might advise the client to sit tight and wait out the period of time. 5. Liquidate the assets and pay the funds to the IRS. If the IRS won't negotiate a reasonable settlement, then consider selling the assets and paying the proceeds to the IRS in settlement of the lien. 6. File a Chapter 13 and pay the value of the assets. In Chapter 13, the debtor may strip the lien down to the value of the collateral and pay that amount over the life of the plan. We have found that the threat of a Chapter 13 may also give some negotiating leverage in settling the lien. 7. File an Offer in Compromise. If the amount of the tax lien is significant, and other alternatives do not work, consider filing an Offer in Compromise. For example, if your client owns a home worth $200,000 and has a lien secured by a mortgage of $160,000, in an OIC the house is presumed to have no equity. (The IRS uses 80% of real estate's value for OIC purposes!) An Offer in Compromise can be a powerful tool in resolving tax liens. The IRS has long taken the position that it will not consider an OIC while a Debtor is in Bankruptcy. Two recent courts have ruled that the IRS must consider a Debtors Offer in Compromise while they are in Bankruptcy. One case involved a Chapter 11, the other a Chapter 13. These cases open tremendous potential. There are numerous other avenues to consider in obtaining a lien release in Chapter 7. E. OTHER BANKRUPTCY REFORM CHANGES Bankruptcy Reform has created numerous other changes in the way taxes are handled in Bankruptcy. A summary follows: a) Means testing does not apply to Tax Discharge matters. i) Taxes are not Consumer Debt. ii) Taxes are involuntary. b) Still must apply for Credit Counseling. c) For budgeting might be able to include secured value of tax claim in budget (divided by 60). i) This is where one of the fights will occur. ii) Ability to pay 10k over 5 years. d) Will use IRS Collection standards to calculate budget for means testing. Query: Will the courts be more likely to require use of these standards in lieu of a more flexible budget? i) Same as we have been doing in OIC, Levy Release, etc. ii) Big departure as IRS standards are very low. iii) If used for budgeting will remove much of the flexibility from the Ch 13 process. e) Tax liens will be useful in Chapter 7 cases to reduce amount of monthly excess income; we will try to divide the amount of the tax lien claim by 60 then deduct that amount from the budget. i) Question- What will this do to estimates of value? ii) Increase them (as ethically permissible) to maximize the secured portion of a claim to reduce excess income? iii) What happens if converted to 13….stuck with high estimates? f) Priority tax claims will be deducted from excess income. i) Useful for budgeting. ii) May make 13 not feasible. g) May not be able to do Chapter 20. New law prohibits a discharge in Chapter 13 if there was a prior discharge within 4 years. Can still file; however no discharge. Still might be useful for payment of priority and secured taxes. h) Will have to provide tax return or transcript to any creditor requesting it. i) in Chapter 13 last 4 tax returns will have to be filed before the 341 hearing. However Trustee can continue 341 hearing to allow taxes to be filed. See 1308 j) If Post petition taxes not filed or paid, then case may be dismissed on motion.
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