Dealing with Taxes During and After Bankruptcy. Types of Pre-Petition Tax and Dischargeability.

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1 Dealing with Taxes During and After Bankruptcy Kent Anderson Kent Anderson Law Office Eugene, Oregon (541) Types of Pre-Petition Tax and Dischargeability. I. Non-Dischargeable Taxes for Individuals under 11 U.S.C. 523(a)(1) a. Priority Tax 11 U.S.C. 523(a)(1)(A); b. Taxes for which a return was due but not filed 11 U.S.C. 523(a)(1)(B); c. Taxes for which the return was filed within two years of the bankruptcy filing 11 U.S.C. 523(a)(1)(B); d. Taxes with Bad Acts 11 U.S.C. 523(a)(1)(C): i. Fraudulent Tax Return; ii. Taxpayer attempt to evade or defeat tax. e. Pre-Petition Tax Penalties for non-pecuniary loss where the associated event was less than three years prior to the bankruptcy filing 11 U.S.C. 523(a)(7). II. Non-Dischargeable Taxes for Individuals who filed tax returns after the IRS has assessed under 26 U.S.C III. Taxes Entitled to Priority a. Taxes due on recent years. b. Taxes recently assessed. c. Taxes assessable but not yet assessed. d. Certain Property Tax e. Withholding Taxes f. Employment Taxes 1

2 g. Excise Taxes h. Customs Duties i. Pecuniary loss penalties Time Required Before Tax Dischargeable IV. Tolling Events for time periods involving Priority Tax a. Prior bankruptcy stay b. Bankruptcy plan prevents collection c. A hearing request such as Collection Due Process (CDP) or Appeal which prohibits collection d. Additional 90 days added if time periods tolled (11 U.S.C. 507(a)(8) hanging paragraph or flush language ) probably only once regardless of the number of bankruptcy cases. V. Income or Gross Receipts Tax for return last due within three years of the bankruptcy filing. a. Due date includes valid extensions. i. Taxpayer estopped from claiming extension after enjoying benefit. ii. Failure to pay tax with extension cannot be used to advance dischargeability date. b. Weekend dates and holidays (emancipation day in Washington DC). c. Natural disasters, combat zone rules or national tragedies do not extend the due date Rev. Rul VI. Taxes assessed within 240 days. a. 240 days is suspended by a pending Offer in Compromise made during the 240 days after assessment. Offer is only pending if it has been accepted for processing. b. When an Offer in Compromise has suspended the 240 period, an additional 30 days is added to the 240 days. 2

3 c. 240 day period suspended by a bankruptcy or other stay in collection plus 90 days. d. Assessment is governed by IRS and is a tax term of art meaning the date the summary record is signed by the assessment officer. Treas. Reg Assessment is the statutorily required recording of the tax liability. Section Assessment is made by recording the taxpayer s name, address, and tax liability. The assessment date is the 23C date. The 23C date is the Monday on which the recording of assessment and other adjustments are made in summary manner on Form 23C and signed by a Service Center officer. IRM VII. Tax that is not assessed but still assessable other than the tax due on unfiled returns, fraudulent returns or returns filed within two years of the bankruptcy filing. a. Unlimited time for assessing tax on fraudulent return b. Possible voluntary extension of assessment statute form 872. c. Unassessed tax excluded from this provision is non-priority and non-dischargeable. VIII. Property Tax incurred prior to the bankruptcy filing date and last payable without penalty within one year of filing. IX. Withholding Tax 11 U.S.C. 507(a)(8)(C) a. Trust Fund Tax 26 U.S.C b. Certain excise and sales taxes collected from customers or uncollected. Does not cover use tax Szostek v. Tex. Comptroller of Public Accounts, 429 B.R. 552, and 562 (Bankr. W.D.Tex. 2010), rehearing granted on different issue, 433 B.R. 611(BAnkr. W.D. Tex. 2010).\ c. No time limit on priority for this type of tax. Tolling periods do not apply. X. Employment Tax -- Employer Share of employment tax on a wage, salary, or commission for which a return was last due within three years of the bankruptcy filing U.S.C. 507(a)(8)(D); a. Tex. v. Pierce (In re Pierce), 935 F.2d 709 (5th Cir. 1991) (unemployment taxes due on employment tax returns filed within three-year prepetition period held to be priority taxes). 3

4 XI. Excise Taxes including real estate excise tax, highway use tax 26 U.S.C. 4481, and gift tax are covered under 11 U.S.C. 507(a)(8)(E) a. Workers Compensation has been found by some courts to be an excise tax. b. Texas franchise tax on domestic and foreign corporations doing business in Texas In re Nat'l Steel Corp., 321 B.R. 901 (Bankr. N.D. Ill. 2005) XII. Customs Duty from importation of merchandise. 11 U.S.C. 507(a)(8)(F) a. Entered for consumption within one year of filing bankruptcy, or b. Covered by entry liquidated or reliquidated within one year of filing bankruptcy; or, c. Entered for consumption within four years of filing bankruptcy under certain conditions involving a treasury investigation. XIII. Penalties associated with a claim set forth in 11 U.S.C. 507(a)(8)(A) (F) in compensation for actual pecuniary loss. The courts struggle with the concept of pecuniary loss. Some courts have found prepetition interest to be such a penalty. No clearly identified penalties in the federal tax code are identified as for actual pecuniary loss. Chapter 13 Cases XIV. Special rules for Chapter 13 cases after BAPCPA. a. Not-so-super discharge. i. Non-priority, non-dischargeable tax such as tax on unfiled returns, late-filed returns, fraudulent returns and tax due where debtor willfully intended to evade or defeat the tax may not be fully paid in plan leaving tax due after discharge. ii. Interest on non-dischargeable tax continues to accrue during the case and eludes discharge. iii. Priority tax must be paid but does not accrue postpetition interest. b. Better than Chapter 7 i. Debt incurred to pay priority tax is discharged in Chapter 13 assuming intent to pay in full when the debt was incurred. 4

5 ii. Nonpecuniary loss penalties do not have to be paid in full and are not exempted from discharge under 11 U.S.C iii. No separate taxable estate and debtor retains all tax attributes including net operating losses. c. Must file missing tax returns. Shall file all tax return for all taxable periods ending during the 4-year period ending on the date of the filing of the petition. Trustee may hold open the meeting for a limited period. 11 U.S.C i. If the return is delinquent, the trustee may hold the first meeting of creditors open for 120 days. ii. If the return is not past due when the returns was filed, the trustee may hold the first meeting of creditors open for the longer of 120 days or the date the return is due under a timely extension. iii. On motion, the court can extend an additional 30 days but not beyond the extension date. iv. A document complying with 26 U.S.C. 6020(a) or (b), a written stipulation for judgment or a final order by a nonbankruptcy tribunal will suffice. v. Upon the failure of the debtor to file a tax return under section 1308, on request of a party in interest or the United States trustee and after notice and a hearing, the court shall dismiss a case or convert a case under this chapter to a case under chapter 7 of this title, whichever is in the best interest of the creditors and the estate. 11 U.S.C. 1307(e). See also 11 U.S.C. 521(e)(2)(B). d. Deficient Plans. The plan (2) shall provide for the full payment, in deferred cash payments, of all claims entitled to priority under section 507 of this title, unless the holder of a particular claim agrees to a different treatment of such claim; 11 U.S.C. 1322(a)(2) i. IRS can permit a deficient plan that fails to pay all priority tax claims of the IRS in full. I.R.M ( ) There are certain factors listed in the Internal Revenue Manual the IRS will consider: 1. Debtor's ability to pay the IRS's claim as required by the Bankruptcy code 5

6 2. Debtor's compliance with filing requirements 3. Probability the plan will pay the IRS more than if the case is dismissed or converted to a Chapter 7 liquidation 4. Debtor's probable ability to continue making payments over the time remaining on the CSED 5. Feasibility of the proposed plan of reorganization 6. Existence of factors precluding the debtor from dismissing the bankruptcy and submitting an administrative offer in compromise ii. Unacceptable Deficient Plans. 1. The plan provides for the payment of claims with lower priority than those of the IRS. 2. If all income not necessary for the health and welfare of the debtor's family or the production of income is not committed to the plan. e. Claims for post-petition tax liabilities. 11 U.S.C Can only be filed by the holder of the claim and not by the debtor. f. Unpaid interest on non-dischargeable tax claims. Debtor may pay the interest through the plan only if it provides for full payment of all allowed claims. 11 U.S.C. 1322(b)(10) What is a Tax Return for Bankruptcy Discharge Purposes? I. Pre-BAPCPA definition. a. Four Part Test under Beard v. Commissioner, 82 TC 766 (1984): i. it must purport to be a return; ii. it must be executed under penalty of perjury; iii. it must contain sufficient data to allow calculation of tax; and iv. it must represent an honest and reasonable attempt to satisfy the requirements of the tax law. II. After BAPCPA a bankruptcy code definition. 6

7 a. The Hanging Paragraph of 523 (added by BAPCPA, eff. Oct 29, 2005) For purposes of this subsection, the term return means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or final order entered by a nonbankrutpcy tribunal, but does not include a return pursuant to 6020(b) of the Internal Revenue Code of 1986, or similar State or local law. 11 U.S.C b. Proposed ABA Taxation Section recommendation would add the phrase other than timeliness to the parenthetical language in this sentence, so that it would read (including applicable filing requirements other than timeliness). III. Substitute for Return 26 U.S.C a. Debtor earns income reported to IRS but fails to file return; b. IRS issues notice to debtor requesting a return or statement as to why no return is due; c. If no response from debtor, IRS issues Notice of Deficiency with 90 day deadline to file in US Tax Court to dispute assessment. d. After 91 days, U.S. Tax Court loses jurisdiction. 26 U.S.C. 6213(a) unless bankruptcy filed. e. IRS assesses tax and commences collection efforts. f. These cases have held that the tax could not be discharged despite the later filing of a tax return by the debtor that meets all other discharge requirements: i. In re Hindenlang, 164 F.3d 1029 (6th Cir. 1999). Late returns having no legal effect do not constitute returns for purposes of 523(a)(1)(B). ii. In re Maroney, 352 F.3d 902 (4th Cir. 2003). [U]njustifiably late returns after SFR assessments are not returns. iii. In re Payne, 431 F.3d 1055 (7th Cir. 2005). Similar holding to Maroney re unjustified delay. IV. IRS litigating position on late filed returns. 7

8 a. Chief Counsel Notice CC A Form 1040 is not disqualified as a return under section 523(a) solely because it was filed late. b. A debt for the portion of a tax that was assessed prior to the filing of a Form 1040 is nondischargeable under 523(a)(1)(B)(i). The debt is not dischargeable because a debt assessed prior to the filing of a Form 1040 is a debt for which a return was not filed within the meaning of section 523(a)(1)(B)(i). V. The McCoy position. If it is not timely filed, it is not a tax return. Tax Liens May Not Go Away VI. Continuing Attachment of Tax Liens post discharge on assets. Special treatment of liens on Spendthrift Property Generally, a bankruptcy discharge does not avoid, extinguish, or release a lien or security interest that was perfected and attached to property prior to commencement of the case. Johnson v. Home State Bank, 501 U.S. 78 (1991); 11 U.S.C. 545(2). a. NFTL Notice of Federal Tax Lien filed. i. Threshold for collection. ii. Possible release b. Unfiled Assessment Lien i. Chief Counsel Memorandum Lien arises when assessment is made and continues until liability satisfied or CSED 26 U.S.C Secret Lien, notice not required 26 U.S.C NFTL filing 26 U.S.C ii. Removal of unfiled tax liens on exempt property. 11 U.S.C. 522(c)(2)(B) 1. Property excluded not exempted 2. Property subject to a valid spendthrift provision is excluded from a bankruptcy estate. 11 U.S.C. 541(c)(2) 8

9 What is a Lawyer to do? 3. Rains v. Flinn, 428 F.3d 893 (9th Cir. 2005); and Wadleigh v. Commissioner, 134 T.C. 280 (2010). But see US v. Rogers, 558 FSupp2d 774 (ED Ohio 2008) and In re Drake, 434 BR 11 (D. Mass. 2010) (involving unperfected Massachusetts tax lien) that agree with the IRS position. 4. The exclusion [of spendthrift property] is permissive rather than mandatory: a debtor's interest in an ERISA-qualified pension plan may be excluded from the property of the bankruptcy estate pursuant to section 541(c)(2)[.] Rains v. Flinn; citing Patterson v. Schumate, 504 U.S. 753, 762 (1992). I. What should the debtor do to ensure the tax liability is extinguished when the case is over and a discharge order has been entered? a. Do nothing. Hope for the best. This may be the preferred course of action. It costs nothing and does not pick a fight. Maybe it will just go away. b. Call to the bankruptcy specialist and ask. If there is a problem with discharge, you may be able to find out what it is. On the other hand, your call may bring unwanted attention. c. File an adversary proceeding against the government. This can be expensive. The IRS may refuse to fight and may move to dismiss for lack of case in controversy. II. Resolving tax liabilities that remain after discharge. a. Wait until collection rights expire. CSED Collection Statute Expiration Date 10- Years 26 U.S.C i. Tolling events for CSED 26 U.S.C ii. Also see 26 U.S.C. 6015(e)(2), 6330(e)(1), 6331(i)(5), 6331(k)(3)(B) and 6672(c)(4) iii. Extension by agreement. iv. Tax liability can be reduced to judgment for additional extension of collections. b. Enter into a payment agreement. IA Installment Agreement 9

10 i. Now Streamlined IA (full financial data and Form 433 not necessarily required) if under $50K in tax liabilities (up from $25K). ii. Now allowed to stretch payments up to 72 months (up from 60 maximum). iii. Partial-Pay IA now allowed if liabilities cannot be paid within the 10-year collection statute expiration date (CSED) periods c. Cut a deal and settle the tax liability. OIC Offer in Compromise i. Formal program authorized by 26 U.S.C The decision to compromise, including whether to consider a compromise and how much to accept, is within the Service s discretion. See Treas. Reg (a). ii. Fresh Start Initiative announced May 21, Greater flexibility in determining equity in assets: e.g., income-producing business asset counted for income, but not also for liquidation value. 20% cost-of-sale discount for most assets. 2. Greater flexibility in allowable living expenses: e.g., allowance for payment of federally guaranteed student loans, payment of state and local delinquent taxes, medical and other special circumstances, miscellaneous can include credit card payments. Financial hardship effects on taxpayer and dependents will be considered. 3. Amount of future income included in computing ability to pay reduced: 1 year instead of 4 for payment within 5 months payments or less (called lump sum cash payment). Or 2 years instead of 5 for payment over more than 5 months and up to 2 years (called periodic payment). 10