TAX DEBT & BANKRUPTCY FOR CHAPTER 13 & CHAPTER 7
CAN TAXES BE ELIMINATED IN BANKRUPTCY?
YES, TAXES CAN BE DISCHARGED IN CHAPTER 7 AND 13 BANKRUPTCY IF CERTAIN CONDITIONS ARE MET:
THE 3 YEARS, 2 YEARS, AND 240 DAY RULES
The Bankruptcy Code sets out specific time periods that determine if you can discharge your taxes, commonly called the 3-year, 2-year, and 240-day rules (the “3-2-240 rules”). To discharge back income taxes, you must meet the requirements of all three rules.
- THE 3-YEAR RULE – To discharge your back income taxes, they must become due at least three years before you file for bankruptcy. However, if you got an extension of time to file, the three-year period runs from the date the taxes are due under the extension.
- THE 2-YEAR RULE – Under the 2-year rule, your income tax returns must have been filed at least two years before you file your bankruptcy petition. This requirement allows you to discharge your taxes even if you file your tax forms late, as long as you file the forms at least two years before filing for bankruptcy.
- 240 DAY RULE – The taxes were assessed at least 240 days before the date of filing of the bankruptcy petition.
The above time periods are tolled (extended) based on certain specific actions such as a prior bankruptcy filing, pending Offer in Compromise, and other limited actions.
EXCEPTIONS TO DISCHARGE UNDER THE 3-2-240 RULES
There are circumstances when taxes are not dischargeable, even though the debtor meets all of the requirements of 3-2-240 rules.
TAX EVASION AND FRAUD – If a taxpayer willfully evades taxes or commits tax fraud, the taxes involved are not dischargeable. §523(a)(1)(C). However, this rule applies only in the case of deliberate tax evasion, not an honest mistake.
UNFILED TAX RETURNS – If a Debtor has not filed a tax return for a tax period that ended pre-petition, the Debtor will not receive a personal discharge for the tax liability relating to that tax period much to the Debtor’s consternation,
TAX RETURN FILED FOR TAXPAYER BY IRS WITHOUT TAXPAYER’S CONSENT – IRS can file tax returns for you and assess taxes against you if and when you do not file a tax return. This can render non-dischargeable, the taxes arising from these substitute returns filed by the IRS if the tax return is filed without your agreement. It is not dischargeable in bankruptcy even if it otherwise meets the 3-2-240 rules. Whether the taxes assessed on tax returns filed for a taxpayer by the IRS are dischargeable depends mostly on whether the IRS filed the forms with or without the taxpayer’s permission. TIP: It is critical you file your tax returns to enable you to discharge them in bankruptcy. Preferably, and to be safe, file them on time, even if you don’t have funds to pay the tax liability arising from the return.
CONSENSUAL SUBSTITUTE TAX RETURNS – A substitute tax return filed by the IRS with the taxpayer’s consent and signature is a considered to be a properly filed tax return, and any taxes arising from it are dischargeable under the 3-2-240 rules.
QUICK NOTE: Do not accept a substitute form as accurate. Just because the IRS has filed a substitute form does not mean you should not file your own form for the same tax year. Very often, substitute forms vastly overestimate taxes. In fact, I have seen substitute forms that were incorrect by tens of thousands of dollars. Therefore, if the IRS files a substitute form, you should have it reviewed by a CPA, and in most cases file your own form. You will likely save money.
IMPORTANT NOTE ON LATE-FILED RETURNS
Unfortunately, a few courts, including a federal appeals court have held that a tax return filed even a day late is not a tax return for the purpose of the statute allowing discharge of tax debts in bankruptcy. In other words, if your forms were filed late without an extension in any given tax year, you cannot discharge the taxes for that year.
In a Chapter 13 case, the Debtor formulates a plan to re-pay their Creditors over a three to five year period. The Debtor makes a single monthly payment to the Bankruptcy Trustee who distributes the payment among the Debtor’s Creditors in the manner set forth in the Chapter 13 Plan. Tax debts are generally non-dischargeable in bankruptcy. However, Chapter 13 can offer significant benefits in dealing with taxing entities.
TYPES OF TAX DEBT: GENERAL UNSECURED, SECURED AND PRIORITY
UNSECURED INCOME TAX DEBT is tax debt for which the IRS has not filed a Notice of Federal Tax Lien with the County Recorder’s Office.
PRIORITY TAX DEBT – Income tax debt classified as priority debt is unsecured tax debt that does not meet the 3-2-240 rules. Other priority debts include certain government charges, child support, maintenance, etc. Priority debts are non-dischargeable in bankruptcy. However, penalties and some interest on priority tax debt may be dischargeable in Chapter 13. (See the Penalties and Interest section below.
EXAMPLE: Lauren files for bankruptcy in 2016. She owes taxes for 2015 and 2014. Because these taxes do not fall under the 3-1-240 rule, they are priority tax debts and are not dischargeable in bankruptcy. Lauren may want to consider if she should wait to file.
SECURED TAX DEBT – If the income taxes are secured by a lien issued by the IRS or other taxing agency, the debt will be listed as secured. Under Chapter 13, the lien is limited to the value of the creditor’s underlying property. The remaining unsecured portion of the debt becomes either general unsecured debt or priority debt, depending on whether it falls under the 3-2-240 rules. Under Chapter 7, the amount of the lien is not reduced and will not be wiped out in the bankruptcy and will remain on your property. It will prevent the IRS from garnishing your wages or bank account, but if the IRS lien is recorded before you file bankruptcy, the lien will remain on the property and you will need to pay it off in order to sell the property
EXAMPLE: The IRS files a tax lien against Mike’s personal and real property of $200,000 for back taxes. Mike has only $30,000 in equity in his home after subtracting the mortgage, and his personal property is worth only $20,000. Mike files for bankruptcy. The total value of Mike’s real and personal property is $50,000. The secured portion of this debt is $50,000. The remainder of $150,000 becomes a general unsecured debt or a priority debt, depending on whether they fall under the 3-2-240 rules.
QUICK NOTE: If you have secured tax debts, it is very important to be as accurate as possible when listing your real and personal property in bankruptcy schedule A/B. Because tax liens are limited to the value of the property in bankruptcy, placing an excessive value your property could prevent you from discharging taxes that would be otherwise dischargeable. If necessary, work with your attorney to obtain valuations or comps for more valuable personal property and consider having a realtor provide a valuation for real property.
INTEREST AND PENALTIES
For the most part, interest and penalties are treated the same in Chapter 7 and 13. However, there are some differences, with regard to priority debts, which we will discuss.
DISCHARGING PENALTIES ON BACK TAXES – Tax penalties more than three years old are dischargeable in both Chapter 7 and Chapter 13 bankruptcy unless the IRS or other taxing agency has secured the debt by filing a tax lien. (See tax lien section below for limitations on tax liens.)
DISCHARGING INTEREST ON BACK TAXES – In both Chapter 7 and Chapter 13, if the taxes are dischargeable, the interest is dischargeable as well.
PENALTIES AND INTEREST ON PRIORITY TAX DEBTS IN CHAPTER 7 – In Chapter 7, penalties and interest on priority tax debts are not dischargeable.
PENALTIES AND INTEREST ON PRIORITY TAX DEBTS IN CHAPTER 13 – All penalties and post-petition interest are discharged in Chapter 13, if the debtor completes the Chapter 13 plan. Therefore, if you have significant penalties on priority tax debt, filing under Chapter 13 may be a better option, particularly if you cannot wait for the taxes to qualify under the 3-2-240 rules.
PENALTIES AND INTEREST ON SECURED TAX DEBTS – Interest and penalties on secured tax debt are not dischargeable up to the value of the security interest in the debtor’s property. (See secured tax debts above.)
POST-PETITION INTEREST ON SECURED DEBTS – Taxing agencies may be entitled to post-petition interest on secured tax debt, which the debtor must pay as part of the plan in a Chapter 13 case.
Income taxes that you incur personally as a result operating a business are dischargeable in bankruptcy under the 3-2-240 rules. However, different rules apply to other business-related taxes:
PAYROLL TRUST FUND TAXES – Trust fund taxes are not dischargeable in bankruptcy. Trust fund taxes include payroll taxes that employer withholds from an employee’s pay on behalf of the government. If you fail to withhold required taxes or withhold the taxes from an employee’s check but fail to pay the withheld funds to the taxing authority, the taxes are not dischargeable.
EMPLOYER’S PORTION OF THE PAYROLL TAX – The employer’s part of the payroll tax (the tax paid directly by the employer for Social Security and Medicare) is dischargeable in bankruptcy under rules similar to the 3-2-240 rules. The debtor must file for bankruptcy a minimum of three years from the date that the IRS 941 form was due and two years from the date the debtor filed the tax forms.
SALES TAX – Like other trust fund taxes, sales taxes are not dischargeable in bankruptcy in Pennsylvania.
THE IRS IS FORCED INTO ACCEPTING AN INSTALLMENT AGREEMENT
In a Chapter 13 case, the Debtor can force the IRS into accepting an installment agreement as part of the Chapter 13 re-payment Plan formulated by the Debtor. The Chapter 13 Plan must provide for full payment, in deferred cash payments, of all tax claims entitled to priority under Section 507(a)(8) of the Bankruptcy Code, unless the taxing entity, such as the IRS, agrees to different treatment.
INTEREST STOPS ACCRUING ON UNSECURED TAX OBLIGATIONS
If the IRS has not filed a Notice of Federal Tax Lien “NFTL” against a Debtor’s assets prior to the date the Debtor initiates a Chapter 13 case, interest stops accruing on the unpaid tax liability. If the IRS HAS filed a NFTL, the tax obligation is secured by the lien, and interest must be paid on the tax debt to the extent of the value of the underlying collateral. For example, if you owe the IRS $8,000, and own property worth $5,000, interest would continue to accrue only on $5,000 of the tax debt. The remaining $3,000 portion of the tax debt would be unsecured.
TAX PENALTIES CEASE TO ACCRUE
From the instant a Debtor files a Chapter 13 case, tax penalties to the IRS and Utah State Tax Commission stop accruing. Moreover, tax penalties are treated in the same manner as all other unsecured claims in the Debtor’s Chapter 13 case. Therefore, if a Debtor’s plan provides for partial payment to unsecured creditors, the Debtor would be permitted to partially re-pay tax penalties also.
CONSIDER AN OFFER IN COMPROMISE TO THE IRS
In a Chapter 13 case, the Debtor must pay all of its Creditors within a three to five year period; and unsecured Creditors are often paid only a fraction of the original debt. Debtors will generally be able to pay their Creditors within this three to five year time period. However, if a Debtor owes a significant amount of nondischargeable tax debt, the Debtor may be unable to repay the tax debt along with all of his or her other debts, within the appropriate time frame. In this case, a Debtor may wish to consider negotiating an offer in compromise with the IRS wherein the IRS may agree to reduce the tax debt and accept favorable terms for repayment of the tax debt.
TAX DEBT AND CHAPTER 7 OPTIONS
In a Chapter 7 case, all property owned by a Debtor becomes the property of the bankruptcy estate upon initiation of the case. The Debtor is permitted to keep all exempt property, and all other property is turned over to the Bankruptcy Trustee for sale and distribution of the sale proceeds to Creditors. Debtors with the non-exempt property they desire to retain should file Chapter 13 bankruptcy to preserve their assets as Debtors are permitted to keep all property in a Chapter 13. In Chapter 7, almost all of a Debtor’s debts are completely eliminated, and the Debtor emerges from Chapter 7 debt free. Certain debts, however, are not dischargeable in bankruptcy, including tax liabilities. Certain tax liabilities, however, may be discharged in bankruptcy.
The above time periods are extended based on certain specific actions such as a prior bankruptcy filing, pending Offer in Compromise, and other limited actions.
TIP: Timing can be important in attempting to discharge old tax liabilities. Consult with a bankruptcy attorney to evaluate the proper time for you to file bankruptcy to enable you to take advantage of the Chapter 7 discharge.
NO INFORMATION CONTAINED HEREIN IS INTENDED TO CONSTITUTE LEGAL ADVICE, AND IS NOT APPLICABLE TO ANY SPECIFIC SET OF FACTS, ESPECIALLY AS TO ANY INDIVIDUAL’S PERSONAL SITUATION. THE INFORMATION CONTAINED HEREIN NOR THE PERUSAL OF IT DOES NOT ESTABLISH NOR CONSTITUTE AN ATTORNEY-CLIENT RELATIONSHIP WITH UTAH BANKRUPTCY PROFESSIONALS OR ANY OF ITS ATTORNEYS. THE INFORMATION SET FORTH ABOVE IS BASED ON NEW BANKRUPTCY LAWS WHICH BECAME EFFECTIVE OCTOBER 17, 2005 KNOWN AS THE BANKRUPTCY ABUSE PREVENTION AND CONSUMER PROTECTION ACT OF 2005 (BAPCPA). BECAUSE OF THE COMPLEXITY OF THE NEW LAWS, PLEASE REFER TO THE ACTUAL BANKRUPTCY CODE AND RULES AND/OR CONSULT WITH A BANKRUPTCY PROFESSIONAL TO EVALUATE THE APPLICATION OF THE ABOVE INFORMATION TO YOUR SPECIFIC SITUATION. (UPDATED May, 2014.)
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