The economic turmoil that has enveloped the United States and much of the rest of the world over the past several years has led to a dramatic increase in the number of bankruptcies. For example, in the 12-month period ending March 31, 2008, bankruptcy filings under all chapters of the U.S. Bankruptcy Code 1 totaled 901,927. They grew to 1,202,503 filings for the 12 months ending March 31, 2009, and to 1,571,183 for the 12 months ending March 31, 2011. The passage of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) 2 in 2005 placed new limitations on Chapter 7 filings under the Bankruptcy Code. 3 Even so, the increase in Chapter 7 cases has been breathtaking. The number filed for the 12 months ending March 31, 2011 (1,118,481), is nearly double that of the 12 months ending March 31, 2008. 4
Besides illustrating the depth of the economic crisis, the increase in bankruptcy filings underscores the importance for businesspersons and professionals of understanding bankruptcy law. Tax accountants, although immersed in the intricacies of the Internal Revenue Code, are not immune from this observation. A failure to anticipate a likely bankruptcy filing, or providing tax advice to a financially troubled client that does not consider the implications of a pending bankruptcy case, could have unintended and costly consequences, including nondischarge of tax debt. Now more than ever, CPAs involved in tax practice must be aware of bankruptcy law and the treatment of tax liabilities in bankruptcy.
This article discusses liquidations under Chapter 7 and focuses on individuals who are attempting to have their debts discharged, or wiped out, in bankruptcy. Corporations are not discussed, as they are not eligible for a Chapter 7 discharge. 5 The article begins with an overview of Title 11 of the United States Code, which contains the bankruptcy provisions, and then describes some of the rules that determine whether an individual debtor can jettison income tax liabilities through a liquidation filing. It also discusses the consequences of certain taxpayer misconduct, including tax fraud. The article concludes with suggestions for tax accountants to follow when working with clients who may be involved in bankruptcy filings, to maximize discharge of income taxes. CPAs must be mindful of other tax issues raised by a bankruptcy petition, however, and should anticipate working closely with a client’s bankruptcy attorney to successfully manage the complex issues raised by the interaction of the bankruptcy and tax codes. 6
Bankruptcy in General
The goals of the bankruptcy law are twofold: to provide a fresh start to debtors and equitable treatment among creditors. Chapters 1, 3, and 5 of the Bankruptcy Code address administrative issues in bankruptcy, such as the automatic stay, which at least temporarily prohibits certain collection actions once a bankruptcy petition is filed. 7 Chapter 7 contains the liquidation rules and is used by businesses and individuals seeking an orderly resolution of debt. 8 Reorganization provisions are found in Chapter 11, which is typically used by corporations, and Chapters 12 (family farm) and 13 (individual plan for the adjustment of debts or a repayment plan). The aim of these proceedings is to restructure debt and, in the case of a corporation filing under Chapter 11, preserve the business as a going concern. A trustee is appointed in Chapter 7 cases and is responsible for collecting and in most cases liquidating or selling the debtor’s nonexempt assets and distributing the proceeds to the creditors. By contrast, a Chapter 11 debtor typically manages the assets of the bankruptcy estate as a “debtor in possession.” 9
A debtor may voluntarily file a bankruptcy petition, or creditors may file an involuntary petition. The filing creates a separate bankruptcy estate that succeeds to all of the debtor’s nonexempt assets as of the commencement of the case. 10 In Chapter 11 reorganization filings, a plan must be developed, classifying the claims against the debtor and describing the treatment of each class. 11 The bankruptcy court must confirm the plan. In liquidation cases, secured creditors are entitled to be paid first with respect to the collateral securing the debtor’s obligations to them. To the extent a secured creditor’s claim actually is secured (meaning that the claim does not exceed the value of the collateral), a secured creditor is entitled to receive either payment of its claim or the collateral. 12 However, the Chapter 7 trustee, whose duty is to maximize the return to a debtor’s unsecured creditors, may sell a secured creditor’s collateral if the asset is worth more than the security interest, to capture the excess for the estate. 13
Thereafter, unsecured creditors entitled to priority under the bankruptcy rules are paid in the order provided by statute. The highest priority is given to domestic support obligations, but administrative expenses, wages, employee benefit plan contributions, and certain other debts are also priority claims. 14 Any assets remaining after all priority claims are paid in full are distributed to the debtor’s general unsecured creditors, who typically receive at most only a fraction of the amount owed to them. Debts that the estate does not pay but that are discharged in a Chapter 7 filing are uncollectible, and creditors are prohibited from taking action against the debtor to recover them. 15 Debts that are not paid and that are excepted from discharge remain liabilities of the debtor following the Chapter 7 bankruptcy. 16
Dischargeability of Federal Income Tax Claims in Chapter 7
Many debtors considering a liquidation bankruptcy do so at least partly hoping to shed tax obligations owed to the federal government. However, the discharge of these debts is subject to precise timing rules that in many cases restrict the ability of debtors to eliminate these obligations. Further, other provisions of Title 11, such as the treatment of perfected federal tax liens and rules regarding property abandoned by the bankruptcy estate, may limit the effectiveness of bankruptcy as a tax relief tool. Therefore, it is important for tax advisers with clients considering a bankruptcy petition to render careful advice about what a filing can and cannot accomplish.
General Limitations on Discharge
Notice of Federal Tax Lien
Even if a debtor is an individual and therefore potentially eligible for the discharge of certain federal income tax debt, a Chapter 7 proceeding will not eliminate exposure on a tax debt for which a notice of federal tax lien (NFTL) has been properly filed before the debtor’s bankruptcy petition is filed. 17 The effect of this notice is to convert the IRS to a secured creditor, allowing it to enforce the lien against the debtor’s prepetition assets even if the tax debt itself is discharged. 18 As a result, “exempt assets,” which a debtor otherwise would be allowed to keep in bankruptcy, could be lost to the payment of taxes. Generally speaking, which assets are exempt depends upon the debtor’s domicile before the filing of the bankruptcy petition, but IRAs and residences are examples of assets that might be claimed as wholly or partially exempt. 19 The possibility of an NFTL can create difficult issues for the timing of a Chapter 7 petition. A debtor seeking to avoid a loss of assets that the exemption rules otherwise would allow the debtor to keep would want to enter bankruptcy before the IRS files an NFTL. 20 Unfortunately, under timing provisions to be discussed later, filing a bankruptcy petition too soon may limit which tax obligations can be discharged.
Postpetition taxes incurred by a debtor also survive a Chapter 7 bankruptcy. This is because a bankruptcy discharge applies only to debts arising before the date of the order for relief. 21 As a result, a calendar-year taxpayer who petitions for Chapter 7 relief on November 30, 2010, for example, will be fully liable for his or her 2010 taxes, since the amount of taxes due cannot be calculated until year end, and the obligation to pay does not arise until April 18, 2011. 22 A planning opportunity exists here, however. Under Sec. 1398 of the Internal Revenue Code, a debtor may elect to close his or her tax year the day before the bankruptcy case commences.
A debtor who makes the Sec. 1398 election files two returns for the year in which he or she enters bankruptcy. The taxes owed for the period ending before the bankruptcy represent a priority claim against the bankruptcy estate and will be paid if there are sufficient assets. Depending upon the circumstances, this payment may be at the expense of the debtor’s general unsecured creditors, whose unpaid claims will be discharged by the Chapter 7 filing. This is because the assets available to satisfy those debts will be reduced by the amount paid to the IRS. If the bankruptcy estate does not have the resources to pay, the priority tax obligation is not dischargeable and remains an obligation of the debtor. 23
Whether the Sec. 1398 election should be made depends on various factors, including the likelihood the bankruptcy estate will be able to pay the short-year prepetition tax and the debtor’s tax situation in the year of filing. For example, a debtor who realizes a significant capital loss in the portion of the tax year occurring before the petition date may not want to make the Sec. 1398 election, to retain the loss for use in later years. Note that a debtor who has no assets other than exempt assets cannot make the Sec. 1398 election. 24
A trustee’s power to abandon property 25 can also complicate the prospective tax relief offered by a discharge because of the potential tax liability if the property returned to the debtor is subject to debt that exceeds its basis. 26 The courts are split on whether abandonment is itself a taxable event. For example, in In re Rubin , 27 the bankruptcy court held that abandonment of property by the trustee was taxable and created liability for the estate. In contrast, the Eighth Circuit, in In re Olson , 28 held that the trustee’s abandonment of encumbered property was not a taxable transaction for the estate. As a result, the debtor would bear the burden of any tax arising on the property’s subsequent disposition.
The magnitude of this problem is illustrated by In re Barker, 29 in which the court approved the abandonment of noncash collateral that included real estate, cattle, crops, and fully depreciated farm machinery. After the expected foreclosure sale, the debtors would owe anticipated capital gains taxes of almost $186,000.
[I]t makes no difference whether the transfer of the property results from a traditional sale of the property or through foreclosure of a lien against the property. Where such property is fully encumbered by liens, or nearly so, the owner of the property may see little or none of the sale proceeds and will need to pay the resulting taxes from other resources. . . .
There can be no doubt that it is a bitter pill to endure a business failure followed by a bankruptcy proceeding and to come out the other end owing a $185,901.00 capital gains tax debt. 30
Although some courts have refused to reach this result, on the grounds it will deny the debtor the fresh start the bankruptcy laws envision, 31 the Barker court ruled that the abandonment and subsequent tax liability for the debtor were dictated by the Bankruptcy Code. 32
Practice tip: Where abandonment is a nontaxable transaction, a debtor should consider triggering foreclosure shortly before the bankruptcy petition is filed, because the resulting prepetition tax would be payable by the estate. 33 On the other hand, if the trustee’s abandonment is treated as taxable to the estate, under Rubin, prepetition foreclosure could be disadvantageous for various reasons. 34
Certain types of taxes are not dischargeable in bankruptcy, further limiting the efficacy of a Chapter 7 petition. These can include taxes that arise because of personal transactions, such as a gift, 35 or because of an individual debtor’s business dealings. For example, a “responsible person” cannot avoid a liability under the trust fund rules of Sec. 6672 through a Chapter 7 petition. 36 The employer’s share of employment taxes on wages earned before the filing and for which a return was due within the three years before the bankruptcy is also nondischargeable. 37 In addition, state sales tax collected by a business may generate an obligation that survives a Chapter 7 proceeding. 38 These latter examples underscore the care a debtor who operates a business must take when considering bankruptcy relief.
Time-Related Limitations on Discharge
Bankruptcy law limits the dischargeability of prepetition income tax claims, based upon a series of timing-related rules included in Section 523 (regarding exceptions to discharge) and Section 507 (regarding priorities) of the Bankruptcy Code. Under these rules, the dischargeability of a prepetition tax claim depends upon whether the debtor timely filed the related tax return, as well as when the return was due, when it was filed, and when the tax was assessed—all in relation to the date of filing the debtor’s Chapter 7 petition. Briefly, a tax claim is dischargeable only if the tax return was due more than three years 39 and was filed more than two years 40 before the debtor’s Chapter 7 bankruptcy petition is filed, and the tax was assessed at least 240 days before the Chapter 7 filing. 41 A tax claim is not dischargeable if the taxpayer never filed the related tax return, 42 or if the taxpayer filed a fraudulent return or willfully attempted to evade or defeat the tax. 43
For income and gross receipts taxes for a tax year ending on or before the date of the filing of the bankruptcy petition (i.e., prepetition tax), the tax debt is not dischargeable if the tax “return, if required, is last due, including extensions, after three years before the date of the filing of the petition.” 44 This rule is applied by looking back three years from the date of filing the bankruptcy petition. Any income or gross receipts tax for which a return was last due, including extensions, within that three-year period is not dischargeable.
Example 1: D, an individual debtor who resides in New York, files her Chapter 7 bankruptcy petition on May 1, 2011. She owes federal income tax for calendar years 2006 through 2010. D timely filed her 2006 return on April 1, 2007 (without extension), filed her 2007 return on April 30, 2008 (with extension), and timely filed her 2008 through 2010 returns (without extension).
D ’s 2006 tax is potentially dischargeable because the return was timely filed and last due (i.e., on April 17, 2007) more than three years before the bankruptcy petition was filed. D ’s 2007 tax is not dischargeable, however, because, taking the extension into account, the return’s extended due date of October 15, 2008, was within three years before the bankruptcy filing. D ’s 2008, 2009, and 2010 income taxes are also not dischargeable because their due dates (April 15, 2009 and 2010, and April 18, 2011) fall within the three years before the petition filing date. 45
Bankruptcy Code Section 523(a)(1)(B)(ii) denies a discharge for tax debts with respect to which a return was filed after the date it was “last due, under applicable law or under any extension, and after two years before the date of the filing of the petition.” Like the three-year rule, the two-year rule involves looking backward from the date of the debtor’s bankruptcy petition filing. The three-year rule looks to return due dates (including extensions) falling within the three-year period preceding the date of filing the bankruptcy petition. By contrast, the two-year rule looks to whether the debtor filed any tax returns late and within the two-year period preceding the bankruptcy petition filing, making the related taxes nondischargeable.
Example 2: Assume that D, described in Example 1, did not timely file her 2006 federal income tax return. If she filed her 2006 return late (and not within a filed-for extension period), but before May 1, 2009, her 2006 tax debt is potentially dischargeable because the return was filed more than two years before the May 1, 2011, filing of the bankruptcy petition. However, if she filed her 2006 return on or after May 1, 2009, the two-year rule would prevent her 2006 income tax debt from being discharged. 46
As this example demonstrates and as discussed below, knowing the exact date a taxpayer’s late return was filed is essential not only in determining whether the tax may be dischargeable, but also in timing the filing of the bankruptcy petition.
To qualify for the two-year rule, a tax return must generally have been filed by the taxpayer and constitute a valid “return” for tax purposes. The test used by the courts to determine whether a return satisfies the statute of limitation also applies for purposes of the two-year rule. 47 As described in Beard, the requirements that must be satisfied are:
First, there must be sufficient data to calculate tax liability; second, the document must purport to be a return; third, there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and fourth, the taxpayer must execute the return under penalties of perjury. 48
A document that purports to be a tax return but that fails to satisfy any of these requirements is not a “return” under the two-year rule. As in Beard, which involved a tax protester, this can include filing an official IRS form that has been tampered with so that it fails to qualify as a return. Where the debtor is not treated as having filed, the tax that should have been reported is not dischargeable.
Sec. 6020 permits the IRS to file a substitute return for a taxpayer under certain circumstances. The BAPCPA amended Bankruptcy Code Section 523 to provide that the term “return” includes a substitute return prepared under Sec. 6020(a) but that a substitute return prepared under Sec. 6020(b) does not qualify. 49 Very generally speaking, a Sec. 6020(a) substitute return is prepared with the taxpayer’s cooperation and signed by the taxpayer, while the IRS prepares the Sec. 6020(b) form, used in fraud and other cases, from IRS employee knowledge, testimony, and other sources, and it is not signed by the taxpayer. 50 As a result of this distinction between the types of substitute returns, if a substitute was filed by the IRS with respect to the debtor, an adviser must know which type of substitute return was filed to determine whether it counts as a return for purposes of the two-year rule.
Courts have reached different conclusions on the effect under the two-year rule of a return filed by the taxpayer following the IRS’s filing of a substitute return. For example, in Hindenlang , 51 the Sixth Circuit concluded that a tax return filed by the taxpayer after the IRS assessed tax pursuant to a Sec. 6020(b) substitute return did not qualify as a return for purposes of Bankruptcy Code Section 523(a)(1)(B). The Sixth Circuit concluded as a matter of law that such a filing is not a return because it “no longer serves any tax purpose or has any effect under the Internal Revenue Code . . . [and] cannot constitute ‘an honest and reasonable attempt to satisfy the requirements of the tax law.’” 52 By contrast, the Fourth, Ninth, and Tenth Circuits consider the taxpayer’s actions in each case to make a factual determination of whether the taxpayer made an honest and reasonable attempt to satisfy the law and, if so, whether the return filed by the taxpayer after the IRS assessed tax pursuant to a substitute return can qualify as a return under the bankruptcy discharge rules. 53
The debtor’s cooperation and timing of filing the return have been noted as considerations in this inquiry. 54 Some bankruptcy courts have taken what appears to be a more extreme position and concluded that the BAPCPA’s amendment of Bankruptcy Code Section 523 to add a definition of “return” has rendered this question moot and eliminated the possibility of discharging tax debt for which the taxpayer did not timely file a return. 55
Outside the post-substitute-return context, additional tax shown as due on an amended return that satisfies the Beard requirements should be dischargeable, provided that no issues of fraud 56 are raised and the applicable time-related limitations to discharge are satisfied.
Observation: At first blush this would appear to require that the original return’s due date (including extensions) be more than three years before, and that the amended return be filed more than two years before, the bankruptcy petition is filed, as well as that any additional tax shown as due on the amended return was assessed at least 240 days before the bankruptcy petition is filed. However, in In re Bisch, 57 the IRS and the taxpayer stipulated that additional 2004 federal income tax reported on an amended return filed in 2008 and assessed on November 5, 2008, was dischargeable in a Chapter 7 bankruptcy for which the petition was filed on August 24, 2009, indicating that where the three-year and two-year rules were satisfied with respect to the taxpayer’s original federal income tax return for the year, the 240-day rule may be the only one applicable to the amended return tax debt. By contrast, the two-year rule applies to state tax liability reported on an amended state income tax return filed later than the applicable state statute requires for reporting federal income tax changes. 58
A third timing rule relates to when a tax obligation has been assessed. An assessment is made by an IRS “assessment officer signing the summary record of assessment,” which in general identifies the taxpayer, the character of the liability assessed, the tax period, and the amount of tax involved. 59 Under Bankruptcy Code rules, prepetition income and gross receipts tax debt are not dischargeable if the tax is “assessed within 240 days before the date of the filing of the petition.” 60 Under this rule, tax that has not been assessed at least 240 days before the bankruptcy petition is filed is not dischargeable. Thus, the key issue for determining the applicability of the 240-day rule is the date of assessment. Since the Bankruptcy Code does not define when tax is considered assessed, the courts have looked to federal income tax authority on this question. 61 Under Treasury regulations, “[t]he date of the assessment is the date the summary record is signed by an assessment officer.” 62
Tax reported as due on a return timely filed by the taxpayer typically is assessed “shortly after the return is filed.” 63 Therefore, from a practical standpoint,
[t]he 240-day period rarely causes priority status [and, as a result, nondischargeability] for taxes that were reflected on a timely filed tax return, as such amounts are assessed shortly after the return is filed. Instead, the 240-day rule is more likely to be applied to additional taxes the Service asserts as the result of an examination, since such amounts will be assessed much later in the process. 64
Generally, before the IRS assesses additional tax (not reported by the taxpayer on his or her return), it must send the taxpayer a notice of deficiency first. The taxpayer may contest the deficiency by filing a petition with the Tax Court. The IRS cannot assess the tax until 90 days 65 following the notice of deficiency (if the taxpayer does not file a petition with the Tax Court) or until any Tax Court determination in the case is final. 66 This can occur long after the original filing date of the taxpayer’s return.
Example 3: T, a debtor, timely filed his 2007 federal income tax return on April 1, 2008, and the IRS promptly assessed the $10,000 tax liability reflected on the return. After an examination of the return, however, the IRS made a deficiency assessment of $15,000 of additional 2007 income tax that remained unpaid when T’s Chapter 7 bankruptcy petition was filed on May 1, 2011.
If the deficiency was assessed before September 3, 2010 (the 240th day before May 1, 2011), the $15,000 tax liability is dischargeable in bankruptcy. However, if the IRS made the deficiency assessment on or after September 3, 2010, the $15,000 tax liability is considered a priority tax and is not dischargeable. 67
In applying the 240-day rule to a tax debt, one must know whether the tax was assessed and, if so, on what date. Taxpayers and their representatives can obtain assessment amounts and assessment date information by requesting the taxpayer’s tax account transcript for the applicable years from the IRS. 68 However, caution is required. The 240-day period is stayed by a number of events, some of which can also lengthen its duration. For example, an offer in compromise of assessed tax 69 that is pending or in effect during the 240 days before the date of the filing of the debtor’s bankruptcy petition tolls the period and expands it by an additional 30 days. 70 If the debtor filed a prior bankruptcy case, the 240-day period also is tolled for the period during which the prior bankruptcy’s automatic stay against collection was in effect, plus an additional 90 days. 71 The Bankruptcy Code also suspends the 240-day (as well as the three-year) periods and adds 90 days “for any period during which a governmental unit is prohibited under applicable nonbankruptcy law from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor.” 72 Thus, a debtor’s collection due process appeal request will suspend and add 90 days to the 240-day period. These suspension and extension rules can make nondischargeable a tax that the debtor otherwise could have eliminated.
Example 4: A deficiency assessment of additional 2007 federal income tax was made against T on June 1, 2010. T filed an offer in compromise of the 2007 tax on August 15, 2010; the IRS rejected the offer on January 15, 2011; and T filed his bankruptcy petition on May 1, 2011.
Because the 240-day period is suspended during the period the offer in compromise was pending and for 30 days thereafter, only 150 days 73 following assessment are deemed to have passed on May 1, 2011. As a result, the tax is not dischargeable in bankruptcy. However, if T had not filed the offer in compromise, the 240 days would have ended on January 28, 2011, and the tax would have been dischargeable.
Unassessed but Assessable Taxes
The 240-day rule (with the modifications discussed above) applies to taxes that have been assessed before the bankruptcy petition is filed. Taxes that have not been assessed before the bankruptcy petition filing that are still assessable “under applicable law or by agreement” after the petition is filed are not dischargeable. 74 As a result, taxes not assessed because the generally applicable three-year period for assessment has not expired will not be eliminated in bankruptcy. 75 Further, taxes still assessable due to a pending Tax Court petition 76 or the taxpayer’s waiver of the statute of limitation on assessment 77 are also not dischargeable. Although petitioning the Tax Court is not necessarily routine, many advisers regularly agree to extend the statutory limitation period while attempting to resolve tax issues. Where bankruptcy is possible, such waivers should be agreed to only with great caution.
As the discussion of the 3-year, 2-year, and 240-day rules makes clear, it is difficult for an individual to eliminate tax obligations in a Chapter 7 filing under even the best of circumstances. It is no surprise, then, that Congress has been even less receptive to discharge of tax debt that involves fraud or evasion. Under Bankruptcy Code Section 523(a)(1)(C), a tax for which the debtor “made a fraudulent return or willfully attempted . . . to evade or defeat” cannot be discharged in Chapter 7, 11, 12, or 13 cases.
The existence of tax fraud in a bankruptcy case is determined by considering all the circumstances, including whether the debtor knew the return was false, his or her intent, and whether there was an underpayment of tax. 78 Regarding a willful attempt to evade or defeat tax, the courts are split on whether nonpayment is enough or if some affirmative act must also be proven. For example, in In re Griffith , the Eleventh Circuit found that mere failure to pay tax was insufficient to constitute a willful attempt to evade or defeat. 79 By comparison, in Toti , the Sixth Circuit denied discharge to a debtor who failed to file returns or pay taxes for eight years. The court found that Toti had “the wherewithal to file his return and pay his taxes, but he did not fulfill his obligation. It is undisputed that he did so voluntarily, consciously, and intentionally.” 80 Regardless of what must be proven, a tax involving fraud or evasion is not entitled to priority under Bankruptcy Code Section 507. 81 This means the debtor will still be obligated to pay the tax after the Chapter 7 case has ended, with very likely little or none of the debt having been satisfied by the distribution of bankruptcy estate assets.
Interest, Penalties, and Debt Incurred to Pay Nondischargeable Taxes
The dischargeability of interest generally follows the dischargeability of the underlying tax. As a result, if an unpaid tax debt is discharged in bankruptcy, the interest on that tax is also eliminated. Similarly, prepetition interest accrued on a nondischargeable tax debt is also nondischargeable. In a Chapter 7 case, interest continues to accrue on a nondischargeable tax claim after filing the bankruptcy petition. If the tax claim is secured, under Bankruptcy Code Section 506(b), the IRS is entitled to receive postpetition interest to the extent that the value of the collateral exceeds the amount of the claim. The debtor remains liable for both postpetition and prepetition interest not paid on nondischargeable taxes. 82 The BAPCPA added Section 511 to the Bankruptcy Code, which provides that the rate of interest on a tax claim “shall be . . . determined under applicable nonbankruptcy law.”
The dischargeability of a tax penalty generally coincides with the dischargeability of the related tax. A tax penalty that is not meant to compensate the government for actual pecuniary loss 83 is dischargeable if it does not relate to a nondischargeable tax. 84 In addition, a tax penalty “imposed with respect to a transaction or event that occurred before three years before the date of the filing of the [bankruptcy] petition” is dischargeable, provided that the penalty is not meant to compensate the government for an actual pecuniary loss. 85 Under this three-year rule for penalties, it is possible for a penalty to be discharged in some circumstances where the underlying tax is not dischargeable.
Example 5: Assume that Q, a taxpayer who resides in Massachusetts, filed a fraudulent 2006 federal income tax return on its due date of April 17, 2007 (without extension). A civil fraud penalty is assessed against Q. Pursuant to Bankruptcy Code Section 523(a)(1)(C), the tax is not dischargeable. However, the fraud penalty, which is not measured by actual pecuniary loss, is dischargeable if Q filed her bankruptcy petition after April 17, 2010. 86
In some cases, a debtor may have borrowed money to pay his or her tax debt before filing for bankruptcy. The Bankruptcy Code provides that debt incurred to pay a nondischargeable tax is also nondischargeable in bankruptcy. 87
Planning Considerations When a Client Is Considering Bankruptcy
For many clients, a CPA is their long-term and primary, if not their only, tax adviser. By contrast, a client deciding whether and when to file a Chapter 7 petition may be consulting bankruptcy counsel for the first time. Given the rules governing the dischargeability of tax debt in bankruptcy, the CPA and bankruptcy counsel should work together to best advise the client on how much, if any, of the client’s income tax debt is dischargeable in bankruptcy. Moreover, because timing is so important in determining dischargeability of tax debt, the advisers should work together to determine the best date to file the Chapter 7 petition, to maximize the client’s income tax debt that can be discharged.
Working with the tax dischargeability rules requires the CPA and bankruptcy counsel to accurately ascertain the facts of the client’s federal income tax return filings, extensions filed for, audit results (if any), and tax payments. Initially, they will need to determine how much tax, penalties, and interest the debtor owes for each tax year. Under the three-year rule, the amount owed for any year for which the return was due (including extensions) within three years of the proposed Chapter 7 petition filing date is not dischargeable. Similarly, under the two-year rule, the amount owed with respect to a return that the debtor filed late and within two years of the proposed bankruptcy petition filing is also not dischargeable. If the client owes tax with respect to a return that was due (including extensions) within three years (or a return filed late and within two years), depending upon the circumstances, it may be advisable to delay filing the bankruptcy petition until after the three-year period (including extensions) or the two-year period, whichever is applicable, has expired, to increase the amount of tax debt that can be discharged in bankruptcy.
Just knowing when the client’s tax returns were due and when the client filed them, however, is insufficient to advise the client on the dischargeability of his or her tax debt and the appropriate date to file the Chapter 7 petition. Moreover, knowing (and, if necessary, being able to prove) those dates can be difficult even in the best of circumstances, and nothing should be assumed. Did the client actually timely file the return or extension form? On what date did the client file a late return? The answers to these questions and others may be difficult to prove without accurate recordkeeping. If the CPA filed the return or extension form for the client, the filing date should be relatively easy to prove, 88 but perhaps not if the client mailed the return or extension form to the IRS.
If uncertainty over return and extension filing dates does not lead the CPA and bankruptcy counsel to request information from the IRS before filing a bankruptcy petition, uncertainty over the tax assessment dates should. The safest way to determine the date of a tax assessment is to review the client’s tax transcript from the IRS. As noted above, taxpayers and their representatives can obtain assessment amounts and assessment date information by requesting the taxpayer’s tax account transcript for the applicable years. 89 With the tax assessment dates in hand, the client’s advisers can then determine whether any amount due was assessed within 240 days of the proposed Chapter 7 petition filing date. If so—again, depending upon the circumstances—it may be advisable to delay filing the bankruptcy petition until after the 240-day period has expired.
The client’s advisers must also review the facts and the tax account transcript to determine or confirm whether the client made an offer in compromise or filed a collection due process appeal (and the dates each was pending). As discussed above, both of these actions stay and add days to the 240-day period, so the advisers must take them into account in determining when to file a Chapter 7 petition. Bankruptcy counsel must also check on whether the debtor previously filed for bankruptcy and, if so, the dates the prior bankruptcy was pending, because the prior bankruptcy can also toll and add days to the 240-day period.
It is also necessary to determine whether the client filed all required federal income tax returns. If the client has not filed a return, the tax is still assessable and cannot be discharged in bankruptcy. The same result applies if what the client filed does not qualify as a return. Any return not prepared by the CPA should be reviewed to determine whether it satisfies the Beard standard. If the IRS filed a substitute return for the client, it will be necessary to determine whether the substitute return was made pursuant to Sec. 6020(a) (which can count as a return for purposes of applying the two-year rule) or under Sec. 6020(b) (which cannot). If the client failed to timely file a return, depending upon the facts and circumstances, advisers should consider whether the client can or should file the return and wait two years before filing a Chapter 7 petition.
These facts and circumstances would require consideration of the client’s overall financial situation. The tax-related considerations would also include, among other things, whether filing the bankruptcy petition sooner may prevent an NFTL from being filed. Also, if the IRS filed a Sec. 6020(b) substitute return, depending on which federal circuit the debtor resides in, a return subsequently filed by the taxpayer may count as a return for purposes of the two-year rule. 90
Advisers also should consider whether and when any of the client’s income tax returns have been or need to be amended. If an amended return shows additional tax due, for it to be dischargeable, at a minimum, the tax would have to have been assessed at least 240 days before the Chapter 7 petition is filed. 91
The client’s tax account transcript (as well as a tax lien search) should reveal whether the IRS has filed an NFTL against the client. If not, and the client has equity in his or her assets, as noted above, it may be desirable to file the Chapter 7 petition sooner to prevent an NFTL’s filing from having any effect on the amount of tax paid in the bankruptcy. However, this potential benefit of an expedited bankruptcy petition filing must be weighed against the amount of any tax, penalty, and interest that would become dischargeable if a Chapter 7 filing is delayed until the 3-year, 2-year, and 240-day rules are satisfied. If an NFTL has been filed, bankruptcy-related planning includes determining the client’s equity in assets to which the lien has attached. To the extent that the amount reflected as due on an NFTL exceeds such equity, the IRS is unsecured, and the dischargeability of the excess amount will require consideration of how the 3-year, 2-year, and 240-day rules apply to the amounts reflected on the NFTL.
Even if the client does not have outstanding income tax liabilities, the CPA and bankruptcy counsel need to know whether the client owes a lender funds borrowed to pay tax. The rule that treats debt incurred to pay tax the same as the tax for dischargeability purposes must be considered and, depending upon the facts and circumstances, may suggest a delay in filing the Chapter 7 petition, again, to satisfy the 3-year, 2-year, and 240-day rules.
Under Bankruptcy Code Section 523(a)(1)(C), a tax for which the client “made a fraudulent return or willfully attempted . . . to evade or defeat” cannot be discharged in Chapter 7. Therefore, it is also necessary to determine whether any tax due reflects a determination that the client committed tax fraud or tax evasion. While a review of the client’s tax account transcript should reveal whether the IRS has assessed fraud-related penalties, the CPA’s history with the client should also shine light upon whether this is possible. Although the tax attributable to fraud is not dischargeable in bankruptcy, the fraud penalty is dischargeable if it is attributable “to a transaction or event that occurred” more than three years before the bankruptcy petition is filed. 92 Again, depending upon the facts and circumstances, it may be advisable to let the remainder of the three-year period expire before filing the Chapter 7 petition, to enable the client to be discharged from the penalty.
A review of a client’s tax liabilities before filing a Chapter 7 petition may reveal that the client has both dischargeable and nondischargeable tax debts. In such a case, prebankruptcy planning should include designating all voluntary tax payments as being paid toward the debtor’s nondischargeable tax debt. 93 For example, the client should designate that he or she is making voluntary payments for more recent tax liabilities that would not be dischargeable under the 3-year, 2-year, or 240-day rules. This planning technique requires additional forethought, because if the client makes the tax payment within 90 days of the Chapter 7 petition filing, the bankruptcy trustee may avoid it as a preference payment. 94 Once the debtor files a bankruptcy petition, payments can no longer be designated. 95
Determining whether a client’s federal income tax debts are dischargeable in a Chapter 7 bankruptcy requires careful analysis of both the intricate bankruptcy tax discharge rules and the client’s tax history and liabilities. Working together, the CPA and bankruptcy counsel may be able to plan the timing of the bankruptcy filing to maximize the amount of the client’s income tax, penalties, and interest that can be discharged and to minimize the income tax debt that is paid in the bankruptcy or survives it.
Authors’ note: The authors gratefully acknowledge the contributions of Elizabeth Blazey to this article.
1 Title 11 of the United States Code.
2 Bankruptcy Abuse Prevention and Consumer Protection Act, P.L. 109-8.
3 Mather and Weisman, BNA Tax Management U.S. Income Portfolios 638-3d, Federal Tax Collection Procedure–Defensive Measures , IX.A.1.
5 Under 11 U.S.C. Section 727(a)(1), only individuals can be discharged from debt under a Chapter 7 proceeding. Corporations seeking relief from creditors can file for reorganization, or restructuring of debt, under Chapter 11.
6 These issues include cancellation of debt income, taxation of the bankruptcy estate, and the bankruptcy reorganization rules found in Sec. 368(a)(1)(G).
7 11 U.S.C. §362.
8 The 2005 bankruptcy legislation introduced means testing, which limits Chapter 7 filings by individuals. Mather and Weisman, Federal Tax Collection Procedure, at A.1.
9 Stern, BNA Tax Management U.S. Income Portfolios 541-4th, Tax Aspects of Restructuring Financially Troubled Businesses, VIII.A.
10 11 U.S.C. §541. The estate in general consists of all legal and equitable interests the debtor holds in property at the commencement of the case; however, the debtor is allowed to exempt certain assets. 11 U.S.C. §522(b).
12 See, e.g., In re Midway Airlines, Inc., 383 F.3d 663 (7th Cir. 2004).
14 11 U.S.C. §507. In certain cases, accountant fees may qualify as administrative expenses. 11 U.S.C. §503(b)(4).
15 Federal Judiciary, “Liquidation Under the Bankruptcy Code.”
16 11 U.S.C. Section 727(b) makes the debtor’s discharge subject to the exceptions to discharge listed in 11 U.S.C. Section 523.
17 IRS Publication 908, Bankruptcy Tax Guide (rev. March 2009). The debtor’s prepetition property is vulnerable because perfected liens generally are not affected by bankruptcy.
18 In re Isom, 901 F.2d 744 (9th Cir. 1990).
19 In general, in a Chapter 7 case, a debtor’s prepetition assets are used by the trustee to pay creditors. For the rules regarding assets exempted from this process, see 11 U.S.C. Section 522. Under this section, a debtor may exempt property as allowed under either the Bankruptcy Code or under federal nonbankruptcy law and state statutes. However, states may limit debtors to state law exemptions.
20 A further timing issue arises under 11 U.S.C. Section 547, which allows a trustee to reverse certain prebankruptcy transactions commonly known as preferences that have the effect of favoring one creditor over another. See Mather and Weisman, Federal Tax Collection Procedure, at IX.B.2, for a discussion of this power in the context of tax cases.
21 11 U.S.C. §727(b). In a voluntary liquidation, filing the petition constitutes the order for relief. 11 U.S.C. §301(b). In an involuntary Chapter 7 bankruptcy, the critical date is the day the bankruptcy court enters the order for relief. In re Kreidle, 146 B.R. 464 (Bankr. D. Colo. 1991).
22 Tatlock, BNA Tax Management U.S. Income Portfolios 540-3d, Discharge of Indebtedness, Bankruptcy and Insolvency. See also Resnick and Sommer, Collier on Bankruptcy, at ¶TX2.05 (Matthew Bender 15th ed. rev.).
23 See generally Resnick and Sommer, Collier on Bankruptcy, at ¶TX2.05. The tax is accorded priority under 11 U.S.C. Section 507(a)(8)(A)(iii) and therefore is nondischargeable under 11 U.S.C. §523.
24 Sec. 1398(d)(2)(C). See also Resnick and Sommer, Collier on Bankruptcy, at ¶TX2.05.
25 11 U.S.C. §554.
26 Tatlock, Discharge of Indebtedness, Bankruptcy and Insolvency, at III.G.
27 In re Rubin, 154 B.R. 897 (Bankr. D. Md. 1992). Rubin involved a Chapter 11 proceeding. An individual debtor is not responsible for taxes incurred by his or her estate in a Chapter 7 bankruptcy case. Mather and Weisman, Federal Tax Collection Procedure, at IX.A.5.d.
28 In re Olson, 930 F.2d 6 (8th Cir. 1991).
29 In re Barker, 301 B.R. 892 (Bankr. D. Colo. 2003).
31 See In re Laymon, 1989 WL 252447 (D. Minn. 1989).
32 In re Barker, 301 B.R. at 897.
33 Tatlock, Discharge of Indebtedness, Bankruptcy and Insolvency, at III G.
35 In re Grynberg, 986 F.2d 367 (10th Cir. 1993) (holding gift taxes owed in a Chapter 11 case on intrafamily transfers occurring within three years prior to filing were nondischargeable excise taxes).
36 In re Mosbrucker, 227 B.R. 434 (B.A.P. 8th Cir. 1998) (discussing this issue in the context of a Chapter 12 filing).
37 Mather and Weisman, Federal Tax Collection Procedure, at IX. A.5.b.
38 See, e.g., Illinois Department of Revenue v. Hayslett/Judy Oil, Inc., 426 F.3d 899 (7th Cir. 2005).
39 11 U.S.C. §§523(a)(1)(A), 507(a)(8)(A)(i).
40 11 U.S.C. §523(a)(1)(B)(ii).
41 11 U.S.C.§§523(a)(1)(A), 507(a)(8)(A)(ii).
42 11 U.S.C. §523(a)(1)(B)(i).
43 11 U.S.C. §523(a)(1)(C).
44 This three-year rule is described at 11 U.S.C. Section 507(a)(8)(A)(i), which describes certain taxes as an eighth-priority claim in the bankruptcy. 11 U.S.C. Section 523(a)(1)(A) provides that such tax claims are not dischargeable, via a cross-reference to Section 507(a)(8).
45 Similar examples can be found at Saltzman, IRS Practice and Procedure ¶16.11 (WG&L 2002–4), and American Bar Ass’n, Effectively Representing Your Client Before the IRS (4th ed. 2009), at 18.104.22.168.1.1.
46 Similar examples can be found at American Bar Ass’n, Effectively Representing Your Client Before the IRS, at 22.214.171.124.1.
47 Beard, 82 T.C. 766 (1984), aff’d, 793 F.2d 139 (6th Cir. 1986).
48 Id. at 777.
49 See the flush language at the end of Bankruptcy Code Section 523(a).
50 See also Regs. Sec. 301.6020-1. Rev. Rul. 2005-59, 2005-2 C.B. 505, provides that neither Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment, nor Form 4549, Income Tax Examination Changes, signed by a taxpayer is considered a Sec. 6020(a) return because it is not signed under penalties of perjury.
51 In re Hindenlang, 164 F.3d 1029 (6th Cir.), cert. denied, 528 U.S. 810 (1999).
52 Id. at 1034 (citations omitted).
53 See In re Moroney, 352 F.3d 902 (4th Cir. 2003); In re Nunez, 232 B.R. 778 (B.A.P. 9th Cir. 1999); and In re Savage, 218 B.R. 126 (B.A.P. 10th Cir. 1998).
54 See Resnick and Sommer, Collier on Bankruptcy, at ¶TX4.02[b].
55 See In re Creekmore, 401 B.R. 748 (Bankr. N.D. Miss. 2008) (“The definition of ‘return’ in amended § 523(a) apparently means that a late filed income tax return, unless it was filed pursuant to § 6020(a) of the Internal Revenue Code, can never qualify as a return for dischargeability purposes because it does not comply with the ‘applicable filing requirements’ set forth in the Internal Revenue Code.”). See also In re McCoy, No. 11-60146 (5th Cir. 1/4/12), In re Brown, No. 10-12087-DWH (Bankr. N.D. Miss. 6/1/11), and In re Weiland, No. 10-14415-DWH (Bankr. N.D. Miss. 5/10/11).
56 For a discussion of fraud’s effect on the dischargeability of tax debt, see p. 110.
57 In re Bisch, 437 B.R. 355 (Bankr. E.D. Mo. 2010). It should be noted that Bisch did not involve allegations of fraud or a substitute return.
58 See, e.g., In re Blutter, 177 B.R. 209 (Bankr. S.D.N.Y. 1995).
59 Regs. Sec. 301.6203-1.
60 The 240-day rule is described at 11 U.S.C. Section 507(a)(8)(A)(ii), which describes certain taxes as an eighth-priority claim in the bankruptcy. 11 U.S.C. Section 523(a)(1)(A) provides that such tax claims are not dischargeable, via a cross-reference to Section 507(a)(8).
61 See Resnick and Sommer, Collier on Bankruptcy, at ¶507.11[b][i] (Matthew Bender 16th ed. rev.), and Saltzman, IRS Practice and Procedure, at ¶16,11, n. 394.
62 Regs. Sec. 301.6203-1.
63 American Bar Ass’n, Effectively Representing Your Client Before the IRS, at 126.96.36.199.1.2.
65 150 days if the notice of deficiency is addressed to a person outside the United States.
66 Secs. 6213(a) and (c).
67 A similar example can be found at American Bar Ass’n, Effectively Representing Your Client Before the IRS, at 188.8.131.52.1.2.
69 An offer in compromise made before the assessment of the tax has no effect on the 240-day period. In re Aberl, 78 F.3d 241 (6th Cir. 1996).
70 11 U.S.C. §507(a)(8)(A)(ii)(I). “An offer in compromise is considered pending from the date the delegated IRS employee signs and dates the acceptance of waiver of the statutory period of limitations on Form 656. . . . An OIC remains pending until it is either accepted, rejected or withdrawn.” In re Nader, No. 98-0685 (Bankr. E.D. Pa. 1999) (citations omitted).
71 11 U.S.C. §507(a)(8)(A)(ii)(II).
72 11 U.S.C. §507(a)(8) (flush language).
73 The 150 days consist of the 75 days beginning June 2, 2010 (the day after the assessment date), through August 15, 2010 (the date the offer in compromise was filed), plus the 75 days beginning February 15, 2011 (the first day after the 30th day following the date the offer in compromise was rejected and no longer pending), through April 30, 2011 (the day before the bankruptcy petition was filed).
74 11 U.S.C. Section 507(a)(8)(A)(iii) makes such unassessed but assessable tax a priority tax, which is nondischargeable under 11 U.S.C. Section 523(a)(1).
75 Pursuant to Sec. 6501(a), absent a substantial omission or fraud or intent to evade tax, the IRS generally has three years from the due date (including extensions) of a filed return to assess tax.
76 Sec. 6503 suspends the statute of limitation on assessment of tax while the petition/case is pending in Tax Court and for 60 days thereafter.
77 Sec. 6501(c)(4) suspends the statute of limitation on assessment of tax during the effective period of an agreement executed by the taxpayer and the IRS that extends the assessment period.
78 In re Jones, 364 B.R. 118 (Bankr. M.D. Fla. 2007), aff’d, 381 B.R. 897 (M.D. Fl. 2008). See generally Resnick and Sommer, Collier on Bankruptcy, at ¶TX4.02[b].
79 In re Griffith, 206 F.3d 1389 (11th Cir.), cert. denied, 531 U.S. 826 (2000).
80 Toti, 24 F.3d 806 (6th Cir.), cert. denied, 513 U.S. 987 (1994). The court concluded that a willful attempt to evade or defeat could include both acts of commission and omission. Id.
81 11 U.S.C. §507(a)(8)(A)(iii).
82 In re Garcia, 955 F.2d 16 (5th Cir. 1992); Bruning, 376 U.S. 358 (1964).
83 11 U.S.C. §507(a)(8)(G). The 100% penalty imposed by Sec. 6672 is an example of a pecuniary loss penalty. In re Garcia, n. 82, above.
84 11 U.S.C. §523(a)(7)(A).
85 11 U.S.C. §523(a)(7)(B).
86 A similar example can be found at American Bar Ass’n, Effectively Representing Your Client Before the IRS, at 184.108.40.206.4 and 220.127.116.11.
87 11 U.S.C. §§523(a)(14) and (14A).
88 Maintaining accurate e-filing records should make proving a filing date easier.
89 See note 68 regarding how to request a copy of the taxpayer’s tax account transcript.
90 See notes 51–58 and the accompanying text.
91 This discussion assumes that there was neither fraud nor a willful intent to evade tax in connection with the original return filing. In addition, depending upon the timing of the original return filing, the three-year and two-year rules may also have some application.
92 11 U.S.C. §523(a)(7).
93 The IRS applies voluntary payments in accordance with the taxpayer’s written instructions. Unless otherwise agreed or required, all other payments are applied “to periods in the order of priority that the Service determines will serve its best interest.” Rev. Proc. 2002-26, 2002-1 C.B. 746.
94 11 U.S.C. §547. See also note 20.
95 Payments received through the bankruptcy proceeding are considered involuntary payments, and absent a court order or confirmed reorganization plan, the IRS applies them in the following order: first, to secured liabilities; second, to unsecured priority taxes; and third, to the tax claim’s unsecured general class. Internal Revenue Manual §18.104.22.168.
Martha Salzman is an adjunct assistant professor, and Arlene Hibschweiler is an adjunct associate professor, both in the School of Management in the University at Buffalo, the State University of New York. For more information about this article, please contact Ms. Salzman at firstname.lastname@example.org or Ms. Hibschweiler at email@example.com.