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BANKRUPTCY AND TAXES

CAN TAXES BE WIPED OUT IN BANKRUPTCY?
YES. READ THIS TO FIND OUT HOW.

The bankruptcy code is an effective tool for the management of any debt, even tax debts.  Under the bankruptcy code , a debt can be discharged (declared legally not due), or modified, depending on its status under the bankruptcy code, which is totally independent of its status under any other body of law.  Bankruptcy can be an effective tool to avoid offsets from various taxing authorities, elimination of tax debt, or compelling taxing authorities to accept payments plans outside of what would normally be permitted by the taxing authority.  The rules cited for the IRS are also the rules followed under the code for any other taxing authority. This article provides a brief overview of what is possible, depending on a taxpayer's particular facts.

Taxes are the debts that are most frequently nondischargeable in bankruptcy cases. However, it is important to realize that not all taxes are nondischargeable. A rather complicated series of cross-references within the Code can be followed to the conclusion that, basically, only the types of taxes listed below are not discharged in a bankruptcy case, however, not being discharged does not eliminate the possibility of a favorable payment plan for the debtor under the code:

  • Any tax for which a return, or equivalent report or notice, if required, was not filed,  for which a fraudulent return, report, or notice was filed,  or which the debtor willfully attempted to evade; 

  • Any tax with respect to which a late return was filed within two years before the date of filing of the bankruptcy;

  • Taxes on income or gross receipts

  • (a) for which a return, if required, was last due within three years of the filing of the bankruptcy, or

  • (b) assessed within 240 days before filing of the bankruptcy, or

  • (c) not yet assessed, but assessable after filing of the bankruptcy;

  • Property taxes assessed before commencement of the case and last payable without penalty less than one year before filing of the bankruptcy;

  • Excise taxes

  • (a) On transactions as to which a return was required and last due less than three years before the bankruptcy, or

  • (b) On transactions, as to which no return was required, which occurred less than three years before the bankruptcy;

  • Taxes required to be collected or withheld by the debtor, such as employment “trust fund” taxes (income taxes and FICA withholding) or sales taxes.

A paragraph added at the end of section 523(a) in 2005 defines “return” as “a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements),” and includes returns filed under Internal Revenue Code section 6020(a) or equivalent state or local law, or stipulated judgments or orders, but does not include returns made pursuant to Internal Revenue Code section 6020(b) (service-filed returns) or equivalent state or local law. Returns filed under Internal Revenue Code section 6020(a) are generally prepared by the taxing authority with the debtor’s assistance based on information and documentation provided by the debtor, whereas a return filed under Internal Revenue Code section 6020(b) is prepared without the debtor’s cooperation and is based on information the taxing authority has obtained on its own. This provision generally codifies the law that when a debtor participates in or signs off on a return, it is considered a return, but when the debtor does not participate in the taxing authority’s creation of a return, it is not. It also clarifies that if the debtor files a return after the taxing authority has already prepared one without the debtor’s participation, that later return does not qualify as a return.

The language requiring a return to satisfy “applicable filing requirements” could be troublesome. What requirements are included? If timeliness were included, it would render the timeliness language in section 523(a)(1)(B)(ii) nearly superfluous. Nonetheless, some courts have held that an untimely return does not qualify as a return under this language. Fortunately, it appears that the Internal Revenue Service does not contend that timeliness is one of the “applicable requirements.”

The 2005 amendments also added rules for calculating the time periods when they have been interrupted by a bankruptcy automatic stay or an offer in compromise. The 240-day period after an assessment in section 507(a)(8)(A)(ii) is extended by any time during which an offer in compromise was pending or in effect during the 240 days, plus thirty days. It is also extended by any time during which collections were stayed in a prior bankruptcy case, plus ninety days.  In addition, language added at the end of section 507(a)(8) provides that all of the time periods in that paragraph are suspended for any period during which collection is stayed as a result of an appeal of a collection action, plus ninety days, plus any time during which collection was stayed in a prior bankruptcy case, plus ninety days. 

Any penalties related to nondischargeable taxes are also nondischargeable, unless the penalty is solely punitive in nature or relates to a transaction that occurred more than three years before the filing of the petition.  Erroneous refunds of nondischargeable taxes are similarly nondischargeable.

 

The treatment of prepetition interest is not as clear; but most courts have held that it is nondischargeable.  Postpetition interest on nondischargeable tax debts is clearly nondischargeable.  And in limited situations, a party who has paid the tax claim of the debtor may become subrogated to the claim and eligible for the same priority and treatment related to dischargeability. 

Occasionally, it is not altogether clear whether a particular debt to a governmental entity is a tax subject to these provisions. Courts consider the debt’s inherent characteristics, especially whether, or how closely, it is related to a debtor’s voluntary use of a service, rather than assessed regardless of the debtor’s actions. Thus, when a charge is assessed only when services are used, in proportion to their use, that charge is not a tax.  At least one court has held that the obligation to repay the First-Time Homebuyer Credit is more akin to a loan than a tax.  Similarly, if the charge is exacted as punishment for an unlawful act or omission, such as early withdrawal of individual retirement account funds, it is a penalty and not a tax.  Nor is the liability under the Internal Revenue Code of a transferee of assets from a taxpayer a tax; it is merely a method of collecting the tax owed by the taxpayer.  On the other hand, revenue collected on an ad valorem basis from all property holders or for a purpose that confers no particular benefit on the payer would be considered a tax.

In addition, even if a tax is an excise tax, it must be an excise tax “on a transaction” to fall under section 507(a)(7)(E). Thus an occupation tax is dischargeable despite the fact that it may be an excise tax, because it is not a tax on a transaction. The Internal Revenue Service takes the position that the penalty under the Affordable Care Act for not obtaining health insurance is an excise tax under section 507(a)(8)(E),184 but some courts have disagreed with that position.

Some, but not all, of the taxes that are nondischargeable in chapter 7 are also nondischargeable in chapter 13. Under section 1328(a)(2), taxes that are described in section 507(a)(8)(C) (taxes required to be withheld or collected by the debtor), section 523(a)(1)(B) (unfiled return or late return filed within two years before petition), and section 523(a)(8)(C) (fraudulent return or evasion) are nondischargeable when the debtor receives a discharge after completion of a plan. If these taxes are paid in full through the plan, the debtor may still owe postpetition interest on them, at least if the plan does not provide otherwise. However, it has also been held that if no claim is filed for taxes described in section 507(a)(8)(C), the taxes are discharged. Other taxes that are nondischargeable in chapter 7, but may be discharged in chapter 13, are priority debts in chapter 13 (which requires a repayment plan to pay certain debts and discharges others) that are required to be paid in full through the plan unless the creditor agrees otherwise or a claim for them is not filed.  And a chapter 13 plan may designate that payments made under the plan be made toward taxes that are nondischargeable rather than those that are dischargeable. 

In some cases, it is to the debtor’s advantage to arrange the bankruptcy filing and the filing of a tax return so that a debt that is nondischargeable in chapter 13 will also be a priority debt. If such is the case, the debtor will be permitted to pay that debt, which will not be discharged, before paying other debts that will be discharged.  For example, a debtor may render an old nondischargeable tax debt, for which no return was filed, a priority debt if the debtor files a return shortly before the bankruptcy case and waits for the assessment to be made before filing the case. The tax is then one that was assessed within 240 days before the petition and is a priority debt, which can be separately classified and paid, with penalties and interest, before other unsecured debts. 

 

Bankruptcy can be an effective tool for managing tax debt, and a wise practitioner will be familiar with the tax related provisions of the bankruptcy code.

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