Using the Bankruptcy Code to Handle
Tax Debts and Stop IRS Collectors
© by Fred W. Daily
Your favorite long time clients, Tom and Martha Taxpayer, have fallen
on hard times. Their business failed, Tom underwent a triple bypass and
Martha had a nervous break down. They got behind on their income taxes
big time while trying to hold things together. Sam Sludge, local IRS Revenue
Officer, unsympathetic by nature or training, is breathing down their necks.
The Taxpayers have been told that bankruptcy can't help them out of their
tax problems and ask you for general guidance. What do you say?
Bankruptcy is a widely misunderstood legal process for debt relief,
including taxes. Filing a petition under one of its provisions (Chapter
7) can often--but not always--erase tax debts. Alternatively, filing under
a reorganization provision (Chapter 11,12, 13) can buy time and force a
repayment plan on the IRS. One of these Chapters in bankruptcy might be
just the answer to Tom and Martha's prayers and offer them a "fresh
The Basics of Taxes and Bankruptcy ----------------------------------
Bankruptcy is begun by filing a "petition" in bankruptcy
court. There are two varieties: "Straight bankruptcy" liquidates
debts (called "Chapter 7"), including some, or all income tax
debts. "Reorganization Plans" (called "Chapter 11, 12 or
13"), force a payment plan for any kind of taxes on the IRS through
a bankruptcy trustee. And, it is sometimes possible to reduce tax bills
in a Chapter 12 or 13 plan similar to an Offer in Compromise.
We'll explain the two types in more detail. First, let's look at
an immediate impact of filing bankruptcy on the IRS. This is the legal
protection to debtors called the "automatic stay." The moment
bankruptcy is filed, all creditors -- including the taxman --are stopped
cold. The only way any collector can overcome the automatic stay while
your bankruptcy case is still active is to apply to the bankruptcy court.
Judges rarely will lift a stay for the IRS, and then it must prove some
kind of fraud is being perpetrated by the bankrupt taxpayer.
The primary downside to Tom and Martha in filing bankruptcy is that
it gives additional time for IRS to collect the debt. If they go into bankruptcy
and emerge from the process still owing the IRS, it gains extra time to
collect the balance. This could happen if the Taxpayers had some, but not
all, of their taxes erased in a Chapter 7. As you know, the IRS normally
has a total of ten years to collect taxes, penalties and interest. Once
a bankruptcy case is over, the IRS gets whatever time remained on the original
ten years, plus the time the bankruptcy case was pending. plus an additional
six months. (Chapter 7's usually take about 3 to 6 months, start to finish.)
Another unavoidable consequence of bankruptcy is it remains on Tom
and Martha's credit record for ten years. However, if tax lien notices
have been filed by the IRS or state tax agency, the credit harm has already
been done. A bankruptcy filing at least shows an effort to deal with the
tax and other debt problem.
Chapter 7 and Taxes
Taxes that can be wiped out in a Chapter 7
"Straight Bankruptcy" -----------------------------------------
In Chapter 7 bankruptcy, the court erases an obligation to pay most
or all debts. However, some debts are "non-dischargeable." Income
taxes can be discharged in a Chapter 7 bankruptcy but only if all of the
following tax code rules are met:
1. The 3-Year Rule: The tax return on which the tax debt arises must
have been due at least three years before you file for bankruptcy. This
usually means April 15 of the year the return was due. If an extension
was filed, then it means August 15 or October 15 of that year, or beyond
to the actual filing date. If the 15th falls on a Saturday or Sunday, the
return wasn't due until the following Monday.
2. The 2-Year Rule: The tax return was filed at least two years before
the bankruptcy (having the IRS file a substitute for return doesn't count).
3. The 240-Day Rule: The taxes were assessed by the IRS at least
240 days before filing.
4. Lack of Fraud/Willful Evasion: There was not a fraudulent tax
return or a willful attempt to evade paying taxes.
5. Income Taxes Only: Taxes other than income, such as payroll taxes,
a 100% penalty, Trust Fund Recovery penalty, fraud penalties, or several
other unusual types of taxes are by law excepted from bankruptcy discharge.
Tolling (Extending)The Waiting Periods --------------------------------------------------------------------------------
Even if Tom and Martha qualify under the above rules, there are other
circumstances that must be considered. Did they file tax returns on extensions?
An extension to file "tolls," or extends the "3-Year Rule"
past April 15th of the third year after the return was due. Other events
can delay the bankruptcy filing date to discharge taxes, including prior
bankruptcies. The time rules (3-Year, 2-Year and 240-Day) are all delayed
by the period in the prior bankruptcy proceeding plus an additional 6 months.
If Tom and Martha filed an Offer in Compromise, the 240-Day period is extended
by the period it is under IRS consideration, plus 30 days.
TIP: Practitioners should always call the IRS to obtain a client's
Individual Master File printout tax transcript for each year with a tax
balance. This computer-generated report gives dates of all time rules for
determining dischargeability in bankruptcy: when taxes were due, filed,
assessed, and dates of any tolling events (Offer in Compromises, prior
Federal Taxes that Don't Qualify for Chapter 7 Discharge -------------------------------------------------------
A Chapter 7 bankruptcy discharge of income taxes wipes out the personal
obligation to pay the tax. A tax lien recorded before filing for bankruptcy
remains. This means that after Tom and Martha's discharge, the IRS has
dibs on any property they had when their bankruptcy was filed. (If Tom
and Martha don't own real estate or have a retirement account, this probably
won't hurt them). However, tax liens survive a bankruptcy discharge only
to the extent of the value of the taxpayer's equity in the property. For
example, a lien of $100,000 was recorded. Tom and Martha had $5,000 of
property when filing Chapter 7. The value of the tax lien is reduced to
Common problems in Chapter 7 cases ---------------------------------------------------------------------------------
Ownership of substantial assets may be a stumbling block for clients
filing Chapter 7. The law allows petitioners to keep some types of property
(called Exempt Property) when filing for bankruptcy. In most states, clothing,
personal effects, furniture, appliances and household goods are exempt.
So are public benefits (such as Social Security, unemployment compensation,
veterans' benefits and worker's compensation). If there is a substantial
amount of equity in a house, or stock certificates or IRA, there is a risk
of losing these items in a bankruptcy filing. This area should be analyzed
by a bankruptcy expert.
Chapter 7 can only be filed once every six years, so if Tom and Martha
filed Chapter 7. in 1993, they are just going to have to wait out the IRS.
Taxes and Chapter 11 Bankruptcy
Chapter 11 bankruptcy is primarily used by larger businesses to protect
them from creditors while attempting to pay off their debts. Individuals
can file for Chapter 11 bankruptcy, but it isn't likely that this complicated
and expensive provision would work for Tom and Martha. Chapter 11 also
has the "automatic stay" feature that stops all IRS collection
efforts. The petitioner has up to 6 years to pay back the IRS in full,
but interest continues to accrue.
Taxes and Chapter 12 Bankruptcy
Chapter 12 is the Family Farmer Reorganization provision, similar
to Chapter 13. Payments to creditors, including the IRS, are made through
the bankruptcy court. Interest and penalties stop when you file the petition.
Taxes and Chapter 13 Bankruptcy
Chapter 13 is the most frequent bankruptcy used by people with tax
debts. It is a debt payment plan, with a monthly payment to a court-appointed
trustee. Chapter 13 bankruptcy repayment plans are for a minimum of three
years and a maximum of five years. Here are six tax tips about Chapter
1. Debts, including some taxes, may not have to be paid in full,
in the discretion of the bankruptcy judge. The debts are referred to as
"crammed down." To be discounted, taxes must be (a) income taxes;
with (b) the returns due more than three years before filing and (c) taxes
were assessed by the IRS at least 240 days ago.
2. To be crammed down, the IRS must not have recorded a lien (or
there is no property for that lien to attach to). Example. The IRS has
recorded a $50,000 tax lien against Doris who files Chapter 13. Doris owns
$10,000 worth of household goods and furniture, and a car worth $5,000.
So, the taxes are secured for $15,000, which may be paid at a discount,
if the judge is convinced this is all Doris has the ability to pay on a
3. If a tax return was due less than three years ago, or the taxes
were assessed less than 240 days ago, or the taxes are not income taxes
(such as for payroll), they are "priority" taxes. Priority taxes
must be paid off in full through the plan. Nevertheless, Chapter 13 stops
interest and penalties the moment it is filed.
By contrast, under an IRS Installment Agreement (IA), interest and
penalties continue to run. So, paying $1,000 per month under an IA for
$60,000 tax bill, leaves a balance of at least $30,000 after five years.
The same payment in a Chapter 13 plan pays off the tax debt in full! In
effect, Chapter 13 forces a repayment plan on the IRS. The IRS cannot get
anything more than the bankruptcy judge approves.
The IRS cannot restart collection activities -- seizures of property
or wages -- as long as a Chapter 13 plan is underway. This is a way to
get around an unreasonable Revenue Officer who won't agree to a fair IA.
In most Chapter 13 plans, the monthly amount paid to the IRS is less than
the rejected IA proposal.
4. Tax penalties may be greatly reduced by the court. Even fraud
penalties, never dischargeable in Chapter 7, might be cut down in Chapter
5. Unfiled income taxes may be paid a fraction on the dollar. Though
actual filing of tax returns more than two years ago is a requirement to
discharge taxes in a Chapter 7, there is no "2- Year Rule" in
6. Tax Liens are extinguished once the Chapter 13 plan has been completed.
To qualify for Chapter 13, the debtor must have a steady stream of
income. It need not be wages -- Social Security, pension payments, and
receipts of an independent contractor all qualify. Unsecured debts --credit
cards, doctor bills, student loans, and taxes that have not been recorded
as a lien-- cannot exceed $250,000. Secured debts--mortgages, car loans,
or taxes for which a lien was recorded--cannot exceed $750,000.
The re-payment plan is submitted to the bankruptcy judge. A hearing
is set for your creditors to come and object to your plan. The IRS rarely
ever objects. The judge may make adjustments to the plan, before approving
it. Then monthly payments are made to the court- appointed trustee, who
in turn, pays the IRS and other creditors.
Combining Bankruptcy Chapters: "Chapter 20 & Chapter 26"
The law allows a tax debtor to file under more than one chapter in
bankruptcy. Why would someone do that? Suppose Tom and Martha file Chapter
7 to wipe out all their qualifying dischargeable taxes. When Chapter 7
is completed, some non-dischargeable taxes remain. Tom and Martha could
simply file Chapter 13 for a repayment plan to deal with the balance. Bankruptcy
gurus tab this strategy: "Chapter 20" (7 + 13). This also stops
interest and penalties.
Likewise, a "Chapter 26" may be a way to spread paying
a tax debt over a longer period-- perhaps up to ten years. This means filing
one Chapter 13 and completing it, and then filing a second Chapter 13 for
remaining debts. If timed right, this can be accomplished before the IRS
starts up collection again.
Dropping Out of a Chapter 13: If Tom and Martha fail to make all
payments under a Chapter 13, interest and penalties on taxes are revived
retroactively, as if they had never been in a Chapter 13. This can be quite
a sum! While revived penalties can be paid at a discount in a subsequent
Chapter 13, the old interest charges remain.
State Income Taxes and Bankruptcy
Generally, the rules are the same for state income taxes as they
are for federal ones. The bankruptcy code only talks about "taxes"
meeting the 3-year rule, 2-year rule, etc. However, there are three traps
for the unwary:
1. Some states send out preliminary notices of state tax deficiencies.
In California, for example, the final date of assessment is 60 days or
more after the proposed additional assessment. This extends the waiting
time to discharge California state income taxes to 300 days So, 60 days
are added to the 240 day federal rule for qualifying state taxes for bankruptcy.
2. California and other states require filing an Amended Return after
an IRS audit assessment. The 3-Year Rule qualification for bankruptcy is
measured from when this Amended Return was due, and the 2-Year Rule from
when it was filed.
3. Most state sales taxes are not dischargeable in Chapter 7. In
Chapter 13, they are treated as priority taxes to be paid in full. However,
due to a quirk in California law, sales tax is imposed on the merchant,
not the customer. Consequently, the tax doesn't fit the bankruptcy code
definition of a "sales tax" and can be discharged in California!
As with income taxes, the California tax must meet the 3-Year and 2-Year
Final Word to the Wise:
The bankruptcy courts are filled with folks who filed cases too early--and
so didn't meet the various strict time rules. For instance, if Tom and
Martha's tax returns were filed two years and 11 months before filing Chapter
7. Or, if taxes were assessed 239 days ago, they will be barred from filing
a new Chapter 7 for six more years. It is not as bad with a Chapter 13
as you can simply drop out and refile after the waiting periods have run.
But, in addition to the period spent in a prior bankruptcy, there is an
additional six months waiting period.
See In re Gushue, 126 B.R. 202 (Bankr. E.D., PA, 2nd Cir., 1991);
In re Rank, 161 B.R. 406 (Bankr. N.D. Ohio, 6th Cir., 1993); In re Bergstrom,
949 F.2d 341 (10th Cir., 1991)
However, one court, at least, found the IRS Form 4549, Income Tax
Examination Changes, may constitute a filed return if the taxpayer effectively
and affirmatively agrees to the assessment - In re Berard, 181 B.R. 653
(Bankr. M.D. Fla., 11th Cir., 1995)
Since the Bankruptcy Code doesn't define "assessment,"
different courts have interpreted the event differently. The 9th Circuit
has said assessment is the "formal act of fixing a tax liability,
and that this act comes after the calculation is completed but may be made
before the amount is due and payable" In re King, 122 B.R. 383 (Bankr.
9th Cir., 1991); One court in the 7th Circuit has defined assessment as
"a formalistic procedure that can be made only after the taxpayer
is sent a notice of assessment and demand for payment" United States
vs. Schweizer, No. 96-2115 (C.D. Ill., 7th Cir., 1996); while yet a third
court has defined it as when "the date the summary record is signed
by an assessment officer," In re Shotwell, 120 B.R. 163 (Bankr. D.Or.,
9th Cir., 1990).
The definition of a fraudulent return is the same as that required
for a civil fraud penalty pursuant to 26 U.S.C. 6653(b), and the evidence
needs to be "clear and convincing" In re Carapella, (Bankr. M.D.
Fla., 11th Cir., 1989). However, the concept of "willful evasion"
is much broader: A failure to file has been found to be a bar to discharge:
In re Brinkley, 176 B.R. 260 (Bankr.M.D., Fla, 11th Cir., 1994); In re
Semo, 188 B.R. 359 (Bankr. W.D.PA, 3rd Cir., 1995); or a truthful return
accompanied with the concealment of assets, In re Jones, 116 B.R. 810 (Bankr.
D. Kan., 10th Cir., 1990)
And while pre-petition interest on a nondischargeable tax is also
nondischargeable, In re Leahley, 169 B.R. 96 (Bankr. D.N.J., 3rd Cir.,
1994), and the same has been held for penalties, In re Hanna, 872 F.2d
829 (8th Cir., 1989), most judges believe that penalties not based on fraud
or the 100% payroll penalty are dischargeable, even if the taxes on which
they are based are not, In re Fox, 172 B.R. 247 (Bankr. E.D. Tenn., 6th
Cir., 1994), so long as they are based on "events or occurrences more
than 3 years old.
But when an Offer in Compromise was processed due to an IRS mistake,
a court has held that there is no tolling: In re Romagnolo, 195 B.R. 801
(11th Cir., 1996). Unless the IRS agrees to less Johnson v. Home State
Bank, 111 S.Ct. 2150 (1991) In re Bracey, 77 F.3d 294 (9th Cir., 1996)
See In re Jones, 158 B.R. 535 (Bankr. N.D. Ga., 11th Cir., 1993) and In
re Lamborn, 204 B.R. 999 (Bankr. N.D. Okla., 10th Cir., 1997) which states
that it is only the additional taxes which would show on the Amended Return
which are measured from the later date. But see In re Dyer, 158 B.R. 904
(Bankr. W.D.N.Y., 2nd Cir., 1993) which measured the dates from the original
By: Frederick W. Daily, Tax Attorney,
John Raymond, Bankruptcy Attorney, and
Allan H. Rosenthal, paralegal.
All of the three have offices in San Francisco.
(This article was originally written for tax
practitioners who represent clients before the IRS. But the information
presented here is valuable for all taxpayers.)
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