DISCHARGING TAXES IN BANKRUPTCY November 25, 2008 California Society of Enrolled Agents Nor Bay Chapter Presented by Attorney Dan Sturm Caveat: This presentation is necessarily very brief in nature and e presenter s intention is to give some background about a VERY complex topic. It is not intended as legal advice for any specific matter or case and should specific advice be required for a client s matter, e advice of an attorney competent in is area of e law should be sought out. Furer Caveat: The bankruptcy law changed as of October 17, 2005 and some of e changes in e new law impact e dischargeability of tax debt. Since e law change, e tax dischargeability rules have been e same for e past ree years. What has changed is how e courts are dealing wi e new law in general.
The biographical sketch: Dan Sturm 4302 Redwood Highway, Suite 100 San Rafael 94903-2143 415-492-0200 tel 415-492-0451 fax dan@sturmlaw.com BA Chico State University (1972) JD Golden Gate University Law School (1978) Admitted to e California Bar in 1978.
I. A Little Background Possible remedies for folks wi delinquent taxes owing to IRS and/or FTB: Simply pay e tax Set up a voluntary installment agreement Dispute (and/or litigate) e underlying tax liability Try an offer-in-compromise Try to get client into uncollectible status Check out e bankruptcy option Short of winning e lottery, paying e tax probably isn t much of an alternative so e oer meods need to be considered. Bankruptcy may be e best alternative for e taxpayer, especially if he/she has oer debt problems to get under control.
II. Discharging Taxes in Chapter 7 What is Chapter 7 bankruptcy: Chapter 7 is straight bankruptcy, at is, it is bankruptcy at liquidates e debtor s non-exempt assets for e benefit of his/her creditors, including tax creditors. When does Chapter 7 work (or alternatively when doesn t it work): In a brief sense (and at term should be taken very literally for purposes of is handout) Chapter 7 works if e debtor doesn t own a home wi equity at exceeds e amount of e homestead exemption under California law (which is $50,000 for a single person, $75,000 for a married person or head-of-household and $150,000 for a senior over 65 years of age or a person wi a disability) and even is can get REAL sticky sometimes). Chapter 7 can be very useful for an individual at doesn t own real estate (a home or oerwise) or have oer significant assets at might be lost to a Chapter 7 trustee. Chapter 7 doesn t work if ere is non-residential real estate at has more an a few dollars in equity or if ere is residential real estate at exceeds e homestead exemption limits, which is more often an not e case wi Marin or Sonoma County clients, given e value of real estate in e Nor Bay. The punch-line is at even if taxes fit e profile for dischargeability in a Chapter 7 case, discussed below, e entire picture has to be looked at from e lawyer s perspective to ascertain if Chapter 7 is e correct way to go. The Chapter 7 tax discharge rules: There are ree fundamental rules (and two additional rules) related to discharging income taxes in a Chapter 7 case (e discussion of oer kinds of taxes, such as sales taxes, is beyond e scope of is presentation): 1) The tax return due date for e tax year sought to be discharged must be at least ree years prior to e bankruptcy filing date (including extension requests). (Example: tax year 2001 taxes come due on 4/15/02, so adding ree years gets to e discharge date of 4/16/04 or later, assuming no extension and assuming at e 15 day of e mon didn t fall on a weekend or holiday.) 2) The taxes must have been assessed at least 240 days prior e bankruptcy filing date. This usually isn t a problem, except in e context of an audit at occurs after e return is filed, which may trigger e running of a new 240 day period after e audit assessment. DETERMINING THE ASSESSMENT DATE IS WHERE THE USE OF AN IRS TRANSCRIPT IS ABSOLUTELY REQUIRED. The above two rules are set for in Bankruptcy Code Section 507, which covers e topic of priority debt which in turn is brought into play by Bankruptcy Code Section 523, e Bankruptcy Code s non-dischargeability section.
3) Lastly, Bankruptcy Code Section 523 requires at e taxpayer must have filed his/her own return more an two years prior e bankruptcy case filing date and (e additional two rules) he/she must not have attempted tax evasion or filed a fraudulent return. How e Chapter 7 tax dischargeability rules work: Three year rule: This rule is mostly mechanical and only requires an analysis (from e transcript) of wheer e taxpayer went on extension, which pushes e ree rule out past e usual April 16 date to eier August 16 or October 16, as e case may be. This rules doesn t get into e issue of e tax payer having actually filed a return or someing at works as return at really isn t a return. 240 day rule: This rule is also mechanical in e sense at 240 days need to be counted from e assessment date as determined from e transcript. However, extra care must be taken to ascertain if e assessment is off e original return filing or is off a later audit assessment. Two year rule: This rule applies for late filed returns, at is, returns filed for years at meet e ree year and 240 day tests but for which a return was filed late. The late filed return must have been filed a least two years prior to e bankruptcy filing for e tax to be dischargeable. Additionally, is rule (technically a separate rule) requires at e taxpayer have filed his own return, which means at if e IRS or FTB files a substitute for return (SFR on e IRS transcript) e two year may not be met. There s a lot of case law on is area as to what constitutes a return, so if e taxpayer signs off on an audit assessment, for example, at may be enough to qualify as a return for bankruptcy purposes. No tax attempt to evade tax and no fraudulent returns: It has been is writer s experience at ese issues don t come up very often, but when ey do, often times a tax protestor is in e works. Tolling events: Certain events will toll or stop e running of e dischargeability periods. For example, an offer-in-compromise will toll e running of e 240 day assessment period if e offer was made during e running of at 240 day period, plus 30 days. There are oer tolling periods as well. Tax liens: Even if a certain tax appears to be dischargeable under e time rules, if a tax lien has been properly recorded in e debtor s county, e taxpayer may not be off e hook. While e personal liability for e tax in is example would be dischargeable, at is, e tax return was filed timely by e taxpayer more an ree years prior to e bankruptcy case filing and e taxes were assessed more an 240 days prior to e filing, e security interest of e tax lien will attach to all e taxpayer s property as of e date of e bankruptcy filing, wi certain nominal exceptions. So if e taxpayer has meaningful
property, even if exempt in e bankruptcy case, if a tax lien has been properly recorded e taxpayer s property (but e not e taxpayer personally) will be liable for e tax. (The lien only attaches to e property as of e bankruptcy filing date; it does not attach to after-acquired property as it does wiout a bankruptcy filing.) III. Discharging Taxes in Chapter 13 What is Chapter 13 bankruptcy: Chapter 13 is a payment plan type of bankruptcy, so it varies from Chapter 7 fundamentally in at e debtor will have to pay a least a part of his/her debt back to e creditors. Chapter 13, in is writer s opinion should be used only when a Chapter 7 case doesn t work. For example, if e debtor has equity in a home beyond e homestead exemption amount, e house may be lost to e trustee in a Chapter 7 proceeding but saved in a Chapter 13. The debtor basically can propose a plan at buys back e equity in e home beyond e exemption, assuming a lot of Chapter 13 tests are met, over a period of ree to five years. Taxes in Chapter 13: The basic ree year and 240 day rules apply in Chapter 13 case, but take on a different bankruptcy result. If e taxes are not old enough to meet e ree year tax return age rule or e 240 day assessment period rule, e tax would not be dischargeable in Chapter 7 and ey concomitantly must be paid 100 cents on e dollar in a Chapter 13 plan, which entails paying not only e going IRS or FTB interest rate, but also a trustee s fee of ten percent of e plan payment amount. Historical broader base of discharge in Chapter 13: Historically Chapter 13, until October 17 of is year, provided for a broader base of discharge in at e two year late filed return (and rule requiring at e taxpayer file his own return) didn t apply in Chapter 13. Additionally, e fraudulent return and wilful attempt to evade tax rules didn t apply in Chapter 13 eier. This broader base of discharge has now been eliminated under e new bankruptcy law. IV. Changes wi e New Bankruptcy Law Fundamental changes: The new bankruptcy law (The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005), which became operative on October 17, 2005, requires e application of a means test if a debtor s debt is primarily consumer debt and his/her income is above e median income for e state in which he/she lives. If e debtor s income in higher an e state s median income for e debtor s household size an income and expense means test is applied; if e debtor s disposable income is too high under e means test, he or she (or ey if a married couple) must file a Chapter 13 case, using some of e IRS expense allowances to ascertain e amount of disposable income at must be committed to e Chapter 13 plan. (While ere s been some academic discussion of wheer tax debt is consumer debt, and most of e cases hold at it isn t consumer debt, most cases won t be just about tax
debt, ere usually being a fair amount of credit card debt involved as well.) Chapter 7 changes related to tax dischargeability: The new law doesn t change e basic tests for dischargeability of tax debt, assuming of course at e taxpayer would qualify in e first instance for Chapter 7 under e new rules. However, one significant change has been made related to e definition of tax return. The current law is vague on e definition of a tax return. The new law clarifies ings is a sense in at it now makes clear at a substitute for return signed by e taxpayer is sufficient as a tax return, but it specifically excludes an SFR not signed by e taxpayer. Note at e new law extends e definition of return to include a equivalent report or notice. That means, for example, when e FTB requires e filing of a report of an IRS audit assessment, at report requirement now takes on e full import of a tax return requirement, which in turn may trigger e two year return i.e. report, requirement. Chapter 13 changes related to tax dischargeability: The basic and fundamental change in e Chapter 13 arena is at e so-called superdischarge (as described above as e broader base of discharge) in Chapter 13 has been eliminated. Therefore, e taxpayer must have filed a return more an two years prior to e Chapter 13 case being filed and e no tax evasion and no fraudulent return rules of Chapter 7 will now apply in Chapter 13 cases. Additional tolling periods: The new law expands e tolling events at stop e running of time periods for tax dischargeability. For example, e new law codifies a US Supreme Court decision [Young v United States 122 SCt 1036 (2002)] by stating at a prior bankruptcy tolls e running of e ree year period and e 240 day assessment period for e active bankruptcy period, plus 90 days. Additionally, e 240 assessment period is tolled when an offer-incompromise is in effect during e 240 period; under e current rules, e 240 day period is only tolled if e offer is made during e 240 period, but e new rule will toll e running of e 240 days even if e offer is made prior to e start of at period. Elimination of so-called Chapter 20: Under e current rules, a debtor could file a Chapter 7 case and get a discharge on unsecured debt and eliminate it from e eligibility dollar limits of Chapter 13 and en immediately file a Chapter 13 case. The new law eliminates at possibility by imposing a new rule providing at four years must elapse between e prior Chapter 7 discharge date and e subsequent Chapter 13 filing in order for e debtor to receive a discharge in e subsequent Chapter 13 case.