- Bankruptcy Tax Issues: Federal Income Taxes
- November 27, 2014
- Law Firm: E. Rhett Buck - Houston Office
- The two remedies available in bankruptcy for federal income taxes are
(1) discharge of tax liability, and
(2) a court-supervised payment plan.
The most beneficial remedy, if available, is to provide a complete and total discharge of the tax liability, which may be obtained under Chapter 7, 11 or completion of Chapter 13 plan. Tax claims are generally dischargeable if a tax claim is not entitled to priority, or not otherwise dischargeable.
A. PRIORITY NONDISCHARGEABLE TAXES:
1. 11 U.S.C. §507(a)(8)(A)(i) (Three Year Rule) - income taxes must be 3 years old
This provision grants priority nondischargeable status to: “income taxes for a taxable year ending on or before the date of the filing of the petition for which a return, if required, is last due, including voluntary extensions, after three (3) years before the date of the filing of the petition."
First, it must be recognized that this provision is keyed to the last date a return can be filed (the due date or extended due date).
In the event the debtor voluntarily obtained an extension of time to file a return, then the three year period is measured from the last day of the extension.
2. 11 U.S.C. §507(a)(8)(A)(ii) (240 Day Rule) - not assessed within last 8 months (plus additions)
This subpart provides that, in addition to the claims noted in subsection (i) quoted above, priority non-dischargeable status is granted to those income taxes assessed within 240 days, plus any time plus 30 days during which an offer in compromise and any time plus 90 days during which another stay in collection proceedings (such as a Collection Due Process Appeal, US Tax Court or US Bankruptcy Court Petition, payment plan request pending, or other proceeding that stays IRS collection action), with respect to such tax, that was made within 240 days after such assessment was pending, before the date of the filing of the petition.”
This situation can occur when an audit or dispute is pending in Tax Court, because the IRS is not permitted to assess and collect the taxes, or when a Collection Due Process Appeal, US Tax Court or US Bankruptcy Court Petition, or other judicial or administrative proceeding that stays IRS collection action, had been filed. The purpose of this provision is to stop a taxpayer from preventing the IRS from having at least a minimal period of time for collection by tying up a determination over assessing or collecting his liability until the tax becomes more than three years old, and then filing a bankruptcy petition which would render the tax dischargeable.
3. 11 U.S.C. §507(a)(8)(A)(iii) (Still Assessable Rule)
Furthermore, this provision provides that in addition to the claims noted in subparts (i) and (ii) quoted above, priority nondischargeable status is granted to income taxes “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.”
This provision covers taxes which are more than three years old that have not been assessed prior to bankruptcy but which can be assessed after bankruptcy under applicable law or by agreement. This, however, does not include those taxes described in 523(a)(1)(B) and (C), which are related to returns which were either filed late or never filed, as well as fraudulent returns. Taxes which are still assessable, even though the 3 year limit for assessments has expired, because the taxpayer signed a Form 872 waiver extending the period of assessment during an IRS audit, are included under this rule, as priority cases.
4. 11 U.S.C. §507(a)(8)(G) (Civil Penalty Priority Rule)
Under this subparagraph, “a penalty related to a claim of a kind specified in this paragraph and is compensation for actual pecuniary loss is a priority claim and is, therefore nondischargeable.”
It appears that the only tax penalty which compensates for a pecuniary loss is the 100% penalty of assessment of trust fund taxes (trust fund recovery penalty). All other penalties for late filing, no filing, late payment, etc., are nonpriority and therefore potentially eligible for discharge, subject to 11 U.S.C. §523- exceptions to discharge.
B. NON-PRIORITY NON-DISCHARGEABLE TAXES
1. 11 U.S.C. §523(a)(1)(B)(i) (No Return Rule)
Under this provision, if no tax return is filed where one is required, then the tax is not dischargeable. Thus taxes which are more than three years old and for which no return was filed or are filed later and are unassessed are not entitled to priority and are not eligible to discharge.
2. 11 U.S.C. §523(a)(1)(B)(ii) (Two Year Rule) - filed at least 2 years (contradicted)
This provision applies to late filed returns. In other words, if a tax is incurred outside the three-year period, it will not be a priority claim, but it will not be dischargeable if the bankruptcy petition was filed within two years from the date the return was filed.
However, the Two Year Rule conflicts with the Timely Filing Rule under §523(a)(19)(hanging paragraph), which appears to state that a return must be timely filed for the taxes to qualify for discharge. This is an item of continuing controversy, but experience suggests it is settled, at least within the Fifth Circuit, and some other circuits. However, even though some professional commentators, and some practicing professionals, have said this provision is not or should not be applicable, or may not be enforced, professionals are seeing the IRS deny discharge for any return for which an SFR was made by the IRS, even though the taxpayer filed a subsequent original return, unless taxpayer signature and agreement to the SFR was obtained under IRC Section 6020(b) - which rarely happens.
3. 11 U.S.C. §523(a)(1)(C) (Fraudulent Return Rule)
This provision excepts from discharge those taxes “(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”
If the tax accrued outside the three-year period was never assessed, then it is not a priority under 11 U.S.C. §507(a)(8)(A)(iii), but is nondischargeable in a Chapter 7, 13 or 11 proceeding.
Examples of fraudulent taxes not dischargeable:
Civil fraud penalty assessed.
Return not filed in good faith (filed more than 7 - 11 years after due) - but see also discussion of Sec. 523(a)(19) hanging paragraph rule.
C. TAX PENALTIES (Penalty Discharge Rule) - penalties follow taxes
Pursuant to 11 U.S.C. §523(a)(7) tax penalties are excepted from discharge. It sets forth:
(7) to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty-
(A) relating to a tax of a kind not specified in paragraph (1) of this subsection, or (B) imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition.
This uniquely-drafted provision simply means that if a tax is nondischargeable, then the tax penalty assessed with it is nondischargeable. If, on the other hand, the tax is dischargeable, then the associated tax penalty is discharged. The same principle applies for accrued interest. The penalty claim, however, will never be entitled to a priority status for distribution pursuant to 11 U.S.C. §727, and Chapter 13 purposes. On the other hand, the interest accrued through the filing of the petition on a nondischargeable tax or in Chapter 13 will always be entitled to priority status for distribution purposes. Practically, however, I do not see, and other practitioners agree, the IRS does not appear to make such distinction.
D. SECURED TAX CLAIMS (Survival of Secured Tax Claims) - Federal Tax Lien survives
It should be noted that, even if a tax claim is dischargeable, if it is secured by a properly filed and perfected lien (if the lien is recorded), the taxing authority may recover its collateral or its “indubitable equivalent”. It is a well-settled principle of bankruptcy law that a secured creditor’s lien, if valid, survives bankruptcy, unless avoided. Furthermore, the discharge does not impair the secured creditor’s right to enforce its lien as to the collateral, even though any deficiency claim may be discharged. Real property and personal property tax liens are required to be properly filed. To remove the tax lien, you can file a Motion to Redeem from IRS; or, as more commonly occurs after the bankruptcy is over, to request abatement of tax collection and release of lien by paying the IRS the value of equity exempted, as shown on the bankruptcy schedules.
In a Chapter 7 proceeding, if the property securing the tax claim is not exempt, it will make little difference to the debtor since the property will be owned by the Chapter 7 trustee anyway, unless abandoned by the Trustee. But, if the property is exempt from collection under Bankruptcy law, it will still be subject to foreclosure or repossession under a tax lien, after the bankruptcy is over, except to the extent the property may also qualify for federal exemptions from levy.
E. CHAPTER 13 DISCHARGE
A Chapter 13 proceeding can be utilized as a viable alternative to deal with tax claims. The old 11 U.S.C. §1328(a) discharge, sometimes referred to as the “super discharge,” is no longer valid law.
11 U.S.C. §1328(a) grants a discharge of all debts provided for in the plan. Additionally, Chapter 13 provides a vehicle in which to repay the priority tax liabilities as set forth below and to ultimately discharge nonpriority taxes.
Pursuant to 11 U.S.C. §1322(a)(2), the debtor must provide for full payment in deferred cash payment of priority claims. However, non-pecuniary tax penalties associated with priority claims are general unsecured claims, which need not be provided for in full. If the plan is completed and the debtor is granted a 11 U.S.C. §1328(a) discharge, then the remaining amount due on the penalties will be discharged even though such penalties could not have been discharged if the debtor obtained his discharge under Chapter 7 or 11. However, priority tax claims must be paid in full within 8 years, so it may be necessary to file for an 8 year Chapter 13 or 11 plan, rather than the more common 3 or 5 year plan. Alternatively, it is possible to get the IRS to agree to a plan that provides for less than full payment of taxes or penalties.
Non-priority, Nondischargeable Claims
If the debtor owes taxes that are not priority claims but are not eligible for discharge, pursuant to 11 U.S.C. §523, these are general unsecured claims in Chapter 13 cases which are paid a pro-rata distribution along with all other unsecured claims. As with penalties, if the debtor completes his plan and is granted a discharge, the tax liability, if also dischargeable in Chapter 7 or 11, would likewise also be discharged upon completion of the Chapter 13.
A mandatory requirement of a Chapter 13 plan pursuant to 11 U.S.C. §1322(a)(2) is: priority tax claims must be provided for “in full” through deferred payments. There is, however, no definition of “in full.” Thus, a question is raised as to whether this language requires the payment of interest. It is clear that similar claims in Chapter 11 cases must be paid with interest under 11 U.S.C. §1129(a)(9)(C). Nevertheless, all cases that have addressed this issue under Chapter 13 hold that no interest is payable. However, if the priority tax claim was secured by the filing of a tax lien, the government is a secured creditor and is entitled to payment of “discount rate” on the amount that is equal to the value of the debtors equity in the property pursuant to 11 U.S.C. §506(b) and 1325(a)(5).
Thus, it is not necessary to provide for interest on unsecured priority tax claims in order to obtain the Chapter 13 discharge available, pursuant to 11 U.S.C. §1328(a). However, it is mandatory to provide for payment of interest or “discount rate” on secured tax claims pursuant to 11 U.S.C. §506. Nevertheless, it does appear from practitioners’ comments that the IRS does not attempt to collect the undischarged interest portion of discharged priority taxes. The interest on discharged nonpriority unsecured taxes is of course discharged.
Post petition interest is generally not recoverable from the bankruptcy estate after the petition date unless a tax lien has been perfected. It may, however, be collected from the remaining assets if the bankruptcy estate proves to be solvent or from property held by the creditor as collateral or from the debtor’s after acquired (post petition) property, exempt and/or abandoned property, if the underlying tax is not discharged.