Let’s just say 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 us for general guidance. What do we 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 start.”
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 taxmen –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-dis-chargeable.” Income taxes can be discharged in a Chapter 7 bankruptcy but only if all of the following tax code rules are met:
- 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.
- 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).
- The 240-Day Rule: The taxes were assessed by the IRS at least 240 days before filing.
- Lack of Fraud/Willful Evasion: There was not a fraudulent tax return or a willful attempt to evade paying taxes.
- 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 bankruptcies, etc.).
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 $5,000.
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 13:
- 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.
- 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 monthly basis.
- 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.
- Tax penalties may be greatly reduced by the court. Even fraud penalties, never dis-chargeable in Chapter 7, might be cut down in Chapter 13.
- 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 Chapter 13.
- 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 dis-chargeable taxes. When Chapter 7 is completed, some non-dis-chargeable 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:
- 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.
- 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.
- Most state sales taxes are not dis-chargeable 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 Rules.
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 8 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.
Be Sure You Have a Tax Lawyer For the Bankruptcy Tax Issues
During bankruptcy proceedings, you’re entitled to an attorney. Although we do not practice bankruptcy law, we can work with your bankruptcy attorney to explore the tax implications and alternative options.