Basic Bankruptcy Treatment of Income Tax for Individuals

Editor: Valrie Chambers, Ph.D., CPA

Bankruptcy & Insolvency

The number of U.S. bankruptcy filings increased 9% from 2009 to 2010 (National Bankruptcy Research Center, 2010 Year-End Bankruptcy Filings Report (January 4, 2011)). With many more people filing for bankruptcy, clients often ask their CPAs, “Can I get rid of the income taxes I owe in bankruptcy?” The answer is “Maybe.” This item attempts to clarify this answer and discusses certain aspects of bankruptcy and other options that CPAs need to be aware of in order to best represent their individual clients. (This piece is limited to income tax for individuals and does not cover other taxes such as employment or property tax or taxes for businesses, including corporations, that are discharged in a chapter 11 bankruptcy. For a discussion of corporate bankruptcy, see DeGeorgio and Chambers, “Tax and Pension Claims in Bankruptcy,” 34 The Tax Adviser 481, 556 (August, September 2003)).

Discharge of Taxes

Taxes can be discharged in bankruptcy in either a chapter 7 or a chapter 13 filing. Under a chapter 7 bankruptcy filing, a taxpayer petitions the courts to discharge his or her debts in their entirety (liquidation). The debtor does get to keep some assets, known as exempt property. Normally, clothing, furniture, and personal items are considered exempt. Funds received from Social Security, unemployment compensation, veterans’ benefits, and workers’ compensation are also exempt.

Under a chapter 13 bankruptcy filing, the debtor develops a plan to repay all or part of his or her debts. The plan is submitted to the judge presiding over the case for approval. The debtor must have steady income in order to qualify for chapter 13. The debtor must make monthly payments to a court-appointed trustee, who then pays the creditors. The time period allowed for payment plans is a minimum period of three years and a maximum of five years (11 U.S.C. §1322(d)). The moment a chapter 13 bankruptcy petition is filed, penalties and interest stop under the automatic stay rules (11 U.S.C. §362). Sec. 6502(a) generally limits the IRS to a 10-year period to collect taxes after an assessment is made. The filing of a bankruptcy petition will toll (pause) the 10-year statute of limitation.

There are five rules taxpayers need to meet in order to discharge income taxes:

• The due date for filing the tax return, as extended, is more than three years before the filing of the bankruptcy petition (11 U.S.C. §507(a)(8)(A)(i));
• The tax return was filed more than two years before the petition was filed (11 U.S.C. §523(a)(1)(B));
• The tax assessment is at least 240 days old (11 U.S.C. §507(a)(8)(A)(ii));
• The tax return was not fraudulent (11 U.S.C. §523(a)(1)(C)); and
• The taxpayer is not attempting to evade taxes (11 U.S.C. §523(a)(1)(C)).

Taxpayers who do not meet these five mechanical rules cannot have their tax liabilities discharged in bankruptcy.

Bankruptcy Procedure

When a bankruptcy petition is filed, the court appoints a trustee. A trustee in bankruptcy, often an individual, is in charge of administering a bankruptcy estate. In a chapter 7 bankruptcy, the estate is considered a separate entity for tax purposes (Sec. 1398(d)). The trustee of the debtor’s estate in any case under title 11 of the U.S. Code (the bankruptcy code) may intervene on behalf of the debtor’s estate in any proceeding before the Tax Court to which the debtor is a party.

Upon the filing of a bankruptcy petition there is normally an automatic stay, stopping the commencement or continuation of proceedings before the Tax Court (Sec. 6871(c)(2)). At this point, the bankruptcy court has jurisdiction instead of the Tax Court. The bankruptcy court has the authority to determine whether it or the Tax Court will handle tax liability or deficiency issues. The bankruptcy court has the right to determine any tax or any penalties attributable to the tax (11 U.S.C. §505(a)(1)). The debtor must file a petition in Tax Court for redetermination of deficiency before a receiver is appointed in order for that court to have jurisdiction over a tax matter (Levine, T.C. Memo. 1987-564). Because the bankruptcy court has jurisdiction rather than the Tax Court during the automatic stay period, any decision made by the Tax Court while the stay is in place is considered void (In re Schwartz, 954 F.2d 569 (9th Cir. 1992)).

A stay will also prevent the IRS from placing or enforcing a lien against the estate, applying any refund of taxes owed to the taxpayer that arose before the filing of bankruptcy against any claim against the taxpayer, or continuing a collection process against the taxpayer that was started pre-bankruptcy petition (11 U.S.C. §362(a)). Under Section 362(b)(9) of the bankruptcy code, a stay does not prevent the IRS from auditing, issuing tax deficiency notices, demanding tax returns, or assessing tax and issuing a notice of demand for payment. The bankruptcy court may lift the stay. If the court does lift the stay, the IRS may petition the Tax Court to continue the pending case.

There are two exceptions to the automatic stay rule whereby the stay is lifted without a bankruptcy court order and the Tax Court has authority to resolve the tax matter:

• If an individual files a bankruptcy case under chapters 7, 11, or 13, and the debtor had a case pending within the preceding one-year period that was dismissed (other than a case refiled under a chapter other than 7 after a dismissal due to abuse by a debtor), the automatic stay terminates for the debtor on the 30th day after the filing of the later (current) case. However, any interested party may petition the bankruptcy court to extend the automatic stay in the second (current) bankruptcy case before the expiration of the 30-day period (11 U.S.C. §362(c)(4)).
• If an individual files a bankruptcy case (or a case is filed for an individual), and the debtor had two or more cases pending within the previous year but those were dismissed (other than a chapter 7 case converted to a chapter 11 or 13 case due to abuse by the debtor), the automatic stay does not go into effect upon the filing of the later (current) case (11 U.S.C. §362(c)(4)).

Tax Liens

An area of bankruptcy that needs special understanding is IRS liens. Liens are handled differently depending on the type of bankruptcy filed. In a chapter 7 bankruptcy, even though the discharge eliminates the debtor’s personal liability for the tax year or years for which there is a lien, a lien against property that the debtor owned at the beginning of the case survives the discharge of the underlying tax liability (11 U.S.C. §522(c)(2)(B); Isom, 901 F.2d 744 (9th Cir. 1990)). In a chapter 7 bankruptcy filing, the tax lien will continue against the pre-bankruptcy property but not against property acquired post-bankruptcy. If the IRS does release a lien against property involving a pre-bankruptcy filing, it cannot refile its lien against this property (Chief Counsel Advice (CCA) 199950001).

In a chapter 13 filing, tax liens that the IRS filed before the commencement of a bankruptcy petition are valued as of the commencement of the case and are generally paid through the plan so that when the debtor emerges from bankruptcy he or she is entitled to a release of lien for all taxes of record. The unpaid IRS assessment is split into secured and unsecured debts. The value of the secured debt that the debtor must pay to the IRS through the plan is the value of the equity in the debtor’s assets to which the lien attaches. The IRS will be paid on the unsecured portion of the lien similarly to how other unsecured creditors are paid. However, if the chapter 13 plan does not fully satisfy the tax liability, the tax lien survives (CCA 200246002).

Alternatives to Bankruptcy

When confronted with the issue of filing bankruptcy because of income taxes, CPAs should advise their clients of alternatives to bankruptcy. They may want to consider recommending that their clients enter into an installment agreement with the IRS, even if they may later file for bankruptcy. The IRS cannot automatically terminate an installment agreement just because the taxpayer has filed for bankruptcy (CCA 199920005). Taxpayers should remember that when taxes are discharged in bankruptcy, the IRS will be unable to pursue the amount due as a personal liability. Often, according to the chief counsel’s office (CCA 200133044), the IRS will not enter into an installment agreement after a bankruptcy discharge because taxpayers have no personal liability to repay the debt. It will agree to payment plan offers when the payments seem likely and the debt will be paid over a short period of time.

There is also the option of filing an offer in compromise (OIC). If an offer is accepted and the taxpayer pays the taxes in accordance with the terms of the OIC, the debt is eliminated. Filing an OIC will toll the 10-year statute of limitation to collect taxes while the IRS is reviewing the offer.

Planning Considerations

When clients have decided to pursue a bankruptcy filing, they will need to do some planning. They must first decide under which chapter to file. There are different advantages to chapter 7 and chapter 13 filings. After a discharge under chapter 7, the individual’s dischargeable tax debt is eliminated. The advantage of a chapter 13 filing is that, assuming the individual has a steady income stream, his or her tax debt can be paid through a realistic payment plan without a liquidation of the individual’s assets.

The timing of the filing also must be considered. There may be taxes that with a delay in filing would become eligible to be included in the bankruptcy petition. If a tax adviser anticipates a capital gain tax on the sale of assets, filing the bankruptcy before the sale would make the tax liability part of the bankruptcy estate and not that of the individual client. If the clients are a married couple and they anticipate a large tax debt that they will be unable to pay, the adviser might consider recommending that they file separately (see Ariail, Smith, Deininger, and Wingfield, “Discharging Taxes in Bankruptcy,” 210 Journal of Accountancy 58 (August 2010)).

In summary, some taxes can be discharged in bankruptcy; CPAs must know which can and which cannot. They should also have a working knowledge of the advantages and disadvantages of filing under the different bankruptcy code chapters so they can properly advise their clients about which type of bankruptcy filing is right for them. If a client wants to file bankruptcy only for the purpose of eliminating taxes, the practitioner should advise the client that there are other options. Filing bankruptcy generally should be the choice of last resort.

EditorNotes

Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, TX. Robert Gard is managing partner of Gard & LaFreniere, LLC, in Alpharetta, GA. They are members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For more information about this column, contact Prof. Chambers at valrie.chambers@tamucc.edu.