This will provide an overview of bankruptcy discharge of taxes. It is important to learn the principles of tax discharge in bankruptcy if you represent clients with tax problems. This is a complicated area of law. The information provided below is only the basics of Bankruptcy Discharge of Taxes and should not be relied on for specific fact situations due to the nuances involved.
I. PRINCIPLES OF CHAPTER 7 DISCHARGE
1. The tax must be over three years old from when the return first came due.
a. Beware of extensions to file the taxes if you are filing after April 15, but before October 15. The tax comes due when the extension runs out.
2. Two years since the tax since the tax return was filed.
a. The tax return must have actually been filed by the taxpayer. Substitute for Returns filed by the IRS do not count.
3. Two hundred and forty days since the tax was assessed.
a. This issue often arises if there is an Examination and an assessment after the return has been filed.
4. Obtain and review tax transcripts to show your clients history
a. We always obtain tax transcripts when there are taxes involved. They will show whether a return has been filed, when it was filed and other necessary information.
5. Tolling events on the time periods. There are numerous events which will toll the periods required for discharge. They may include (depending on which principle they apply to):
a. Prior Bankruptcy
b. Offer in Compromise
c. IRS administrative appeals
d. These tolling events are complicated and research is needed to see if a particular event is applicable to individual cases.
II. ASSESSABLE BUT NOT ASSESSED
1. 11 USC 507 (a) (8) (A) (iii) provides that if a tax is not assessed, but is assessable, it is a priority tax. This usually occurs when Debtor has taxes which are over 3 years old. If the taxpayer filed the return between 2 and 3 years before the Bankruptcy Petition, the tax remains assessable until the tax is over 3 years old. (The IRS has 3 years from when the tax return was filed to assess the tax, with some exceptions). There may be a gap where the IRS can assess the tax and if so, the tax is assessable but not assessed. This may arise in a situation where the IRS is doing an examination of the taxpayers returns.
III. 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:
a. Less than three years old, or;
b. Less than two years since the tax return has been filed,or;
c. Less than 240 days since assessment.
d. Payroll Withholding Taxes
e. Other Priority Taxes
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.
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 11 or 13 plan and are not subject to discharge in a Chapter 7. Priority Taxes are not paid interest in Chapter 11 or 13, however. Penalties are sometimes treated as unsecured. This favorable treatment often allows a Chapter 11 or 13 plan to deal with the taxes on a more favorable basis.
5. Sales Tax: If the sales tax a tax on the buyer, (it is in Idaho) it is treated as a trust fund tax which is not subject to discharge. In some states it is a tax on the seller and may be subject to discharge.
IV. Tax Liens and Bankruptcy
1. 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.
2. 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.
3. 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 (not likely these days), or the Mortgage is paid down, significantly, the lien creditor (the IRS or ISTC) gains the benefit of the appreciation or principal reduction in the property value.
4. For a thorough discussion, holding that the lien is not stripped down to the value of the collateral see Dewsnup v. Timm 112 S.Ct. 773.
5. Methodology for dealing with Tax Liens:
a. Challenge the validity of an invalid Tax Lien.
b. Requesting a Certificate of Release from the IRS.
c. Negotiate a release for an amount to be paid.
d. Advise client to wait out the Statute of Limitations.
e. Liquidate the assets and pay the funds to the IRS.
V. OTHER BANKRUPTCY TAX ISSUES
a.Means testing does not apply to Tax Discharge matters.
b. Taxes are not Consumer Debt.
c. Taxes are involuntary.