INTRODUCTION TO BANKRUPTCY CODE REMEDIES 101 Overview......................... 1 115 Glossary......................... 2 125 Advantages and Disadvantages of Tax Remedies....... 6.01 Tax Code remedy: statute of limitation on collection.............................. 6.02 Tax Code remedy: installment agreement........ 6.03 Tax Code remedy: offer in compromise......... 6.04 Bankruptcy Code remedy: Chapter 7.......... 7.05 Bankruptcy Code remedy: Chapter 11.......... 8.06 Bankruptcy Code remedy: Chapter 13.......... 8.07 Bankruptcy Code remedy: Chapter 20.......... 9.08 Pay the Tax...................... 9
INTRODUCTION TO BANKRUPTCY CODE REMEDIES "ANOTHER FINE MESS YOU GOT ME INTO." Oliver Hardy to Stan Laurel 101 Overview Remedies for tax liabilities are found in both the Bankruptcy Code and the Internal Revenue Code (Tax Code). You are fully immersed in the field when someone asks what the "Code" says and you answer "Which Code?" For the most part, Tax Code remedies are formulaic. The statute of limitation on collection is ten years. Once the time period runs, the taxpayer no longer has to pay. The offer in compromise is also formulaic. If taxpayers A and B have the same assets and liabilities, the amount offered under the offer formula should be the same, even if taxpayer B owes more than taxpayer A by a factor of ten. Certainly, there are arcane twists to the rules, but the Tax Code remedies only take up one chapter (Chapter 2). The Bankruptcy Code is a byzantine creation, which rivals the Tax Code for arcane rules and strange twists. It divides the debtor's assets among competing creditors and determines which debts are nondischargeable. As a result, the book is designed to follow the treatment of a claim. As to creditors, the issue of payment priority is of paramount importance, and Chapter 3 discusses the IRS's priority and payment rights in the context of secured claims. Chapter 4 discusses the IRS's priority and payment rights in the context of unsecured claims in Bankruptcy Code Chapter 7. Chapter 5 discusses the IRS's priority and payment rights in the context of Bankruptcy Code Chapters 11, 13, and 12. As to debtors, the issue of eliminating the debt, i.e., dischargeability, is of paramount importance. Chapter 6 discusses dischargeability of tax debts. Chapters 3 through 6 discuss the different types of tax claims, i.e., prepetition and postpetition tax, interest, and penalties, on an ad hoc basis. Chapter 7 reviews the rules applicable to tax, interest, and penalty, and it devotes a cchch1a.wpd -1-
separate paragraph to the unique prepetition and postpetition treatment of each. Chapter 8 discusses issues related to unliquidated claims. With the passage of the Bankruptcy Abuse Protection and Consumer Protection Act of 2005 (BAPCPA), tracking the treatment of a claim left many important rules undiscussed. Chapter 9 discusses the hurdles to receiving a bankruptcy discharge imposed by BAPCPA. Chapter 10 is a combination of Tax Code and Bankruptcy Code ideas to deal with the responsible person penalty. The Appendix contains numerous practice tools. There are advantages and disadvantages to each remedy. Often, a particular marker points to the appropriate remedy. A ten-year old tax debt indicates that the statute of limitation on collection should be considered. This is because the ten-year collection statute may have run or be ready to run. A client with a live-in significant other who wants to eliminate a tax debt before getting married is often a candidate for an offer in compromise. The significant other is often a good source for the money needed to fund an offer. A tax debt of medium age, e.g., five years, and no other striking facts, e.g., an offshore trust, indicates that Chapter 7 may be appropriate. Like many disciplines, learning the appropriate remedy is a matter of learning the rules, being thoughtful, and obtaining a little experience. This text provides an introduction to both tax and bankruptcy rules for remedying tax liabilities. It provides practical tools and tries to guide the practitioner toward the best remedy for a client s specific situation. Often, there is not a best remedy, and, the text tries to point out the advantages and disadvantages among the available remedies. By way of introduction to the Bankruptcy Code, a glossary of terms used in bankruptcy is provided in 115. This is followed in 125 with a brief comparison of the advantages and disadvantages of the various Tax Code and Bankruptcy Code remedies. 115 Glossary Since most users of these materials understand tax, this introduction to Bankruptcy Code remedies first sets out a glossary of terms used in bankruptcy. The ordering of the terms is designed to provide a beginner's understanding of bankruptcy. After the glossary, 125 briefly reviews the advantages and disadvantages of the Tax Code remedies, see, Chapter 2. It then cchch1a.wpd -2-
sets forth the advantages and disadvantages of the available Bankruptcy Code remedies. 1. Insolvency: Inability of a person to pay obligations as they come due. (This definition notwithstanding, 1 the Tax Code uses a balance sheet test for insolvency. ) 2. Bankruptcy: Act of filing petition for relief from creditors under Title 11 of the United States Code (cited as 11 U.S.C. ). 3. Bankruptcy Court: Federal court where the petition for relief is filed and the case is administered. 4. Debtor: Person who owes money, and, except for involuntary cases, the person who files petition for relief. filed. filed. 5. Prepetition: Time period before the petition is 6. Postpetition: Time period after the petition is 7. Bankruptcy Estate: Assets of a debtor administered in bankruptcy; created automatically at commencement of case. 8. Exempt Assets: Portion of an individual's assets excluded from the bankruptcy estate. This exclusion helps provide the individual debtor with a fresh start. debtor. 9. Creditor: Person who holds a claim against the 10. Claim: Potential right to payment from bankruptcy estate assets. Claim is a prepetition concept; postpetition, an entity files a request for payment of an administrative expense. 11. Secured claim: Claim protected by rights in property that assure payment, whether by voluntary agreement (security interest, deed of trust, or mortgage), court order (judgment lien), or operation of law (statutory lien). 1 I.R.C. 108(d)(3). cchch1a.wpd -3-
12. Priority: Ranking of creditor's claim for purposes of asset distribution. Bankruptcy does not work like a soup kitchen, where every person receives an equal amount. In bankruptcy, the first person or class is paid in full before the next person or class receives a distribution. Thus, one's ranking is important. Secured creditors come first as to assets in which they have a security interest. Creditors holding certain administrative expenses and claims are next-in-line. The debtor comes last. As an adverb that modifies tax, i.e., priority tax claim, priority refers to the class of general unsecured tax claims that comes first. 13. Discharge: Goal of debtor in bankruptcy, i.e., removal of legal obligation to pay creditors. If the legal obligation cannot be removed, a debt is nondischargeable. 14. Type 1, Type 2, and Type 3: Based on the concepts of priority and dischargeability, the author divides the world of unsecured tax, penalty, and interest claims of individuals in Chapter 7 into three parts: Action Indicated Type 1: Priority/Nondischargeable Pay or delay Type 2: Nonpriority/Nondischargeable Take corrective action, if possible Type 3: Nonpriority/Dischargeable Chapter 7 In Chapter 7, from the taxpayer's perspective, Type 3 (nonpriority/dischargeable), e.g., a very old income tax obligation, is good because the tax can be discharged. Prior to the passage of BAPCPA, the chart looked as follows: Action Indicated Type 1: Priority/Nondischargeable Pay or delay Type 2: Nonpriority/Nondischargeable Chapter 13 Type 3: Nonpriority/Dischargeable Chapter 7 From a tax perspective, the centerpiece of BAPCPA was the elimination of special treatment for Type 2 taxes in Chapter 13. The superdischarge for taxes was all but eliminated, cchch1a.wpd -4-
2 except for tax penalties. Thus, the table now reads "take corrective action, if possible." For example, if the debtor is a nonfiler, returns will need to be filed and the debtor will need to wait two years. Unfortunately (from the debtor s perspective), case law is developing that indicates that all taxes on late-filed returns are Type 2 and never dischargeable. 3 If the debtor committed fraud, it may be impossible to take any corrective action. Chapter 13 is no longer a simple way to deal with Type 2 taxes. CAUTION: After BAPCPA, the classification of taxes into three types is still useful, although the action indicated is not so stunningly clear. These three types still set forth the universe of possible taxes, and, there is value in simplifying a complicated subject. Outside of this book, this classification system is not used. 15. Chapters 7, 11, 13, and 12: Title 11 of the United States Code authorizes the filing of bankruptcy petitions for individuals under Chapters 7, 11, 13, or 12. Chapter 7 provides for the liquidation of the debtor's assets. Chapter 11 provides for a payment of creditors through a Chapter 11 plan of reorganization. Chapter 13 is known as the adjustment of debts of an individual with regular income, and, it provides for the payment of creditors through a Chapter 13 plan. Chapter 12 is the adjustment of the debts of a family farmer or family fisher with regular annual income, and, it provides for the payment of creditors through a Chapter 12 plan. Chapter 12 contains many special debtor-friendly rules not found in other chapters. See, 535. For example, it allows debtors to convert potential priority/nondischargeable tax debt that arises from the sale of farm or fish assets into nonpriority/dischargeable tax debt. 16. Trustee: Person who administers the bankruptcy estate. The trustee conserves and manages the assets of the bankruptcy estate. In Chapter 11, the debtor can be the trustee, and, that debtor is known as a debtor-in-possession. 2 In addition to tax penalties, the superdischarge eliminates postpetition interest on all priority taxes in Chapter 13, except for trust fund taxes and debt incurred to pay a tax that would otherwise be Type 2 and nondischargeable. 3 This issue is discussed in detail in 635. cchch1a.wpd -5-
In Chapter 13, the Bankruptcy Code provides for the appointment of a standing trustee who administers Chapter 13 cases in that district. The Bankruptcy Code also provides for the office of United States Trustee. In a perfect world, creditors would closely monitor the debtor to insure fair and efficient administration. In the real world, creditors often have an insufficient economic interest in the bankruptcy estate; therefore, they ignore the bankruptcy process altogether. The United States Trustee monitors the system to insure fair and efficient administration. 125 Advantages and Disadvantages of Tax Remedies This paragraph briefly discusses the advantages and disadvantages of both Tax Code and Bankruptcy Code remedies..01 Tax Code remedy: statute of limitation on collection. The advantages of allowing the statute of limitation on collection to run include discharge of the tax liability without payment and release of underlying liens. The disadvantages include the difficulty of withstanding ten years of collection activity, including heightened collection activity prior to the statute's expiration, and the possibility that the IRS may renew the taxpayer's liability with a court proceeding..02 Tax Code remedy: installment agreement. The advantages of an installment agreement include (i) the creation of breathing space free from examination by the IRS; (ii) the possibility of full payment; and (iii) the possibility of hardship status when payment is not possible. Disadvantages of the installment agreement include (i) an impossibly strict budget to live on; and (ii) the likelihood that a notice of tax lien will be filed..03 Tax Code remedy: offer in compromise. The advantages of the offer in compromise include (i) discharge by the taxpayer of unsecured liabilities that are nondischargeable in bankruptcy; (ii) discharge of liabilities without payment in full; and (iii) removal of the tax lien, which cchch1a.wpd -6-
might otherwise remain attached to property after a Chapter 7 filing. The disadvantages to the offer are as follows: (i) formulating an acceptable offer is incredibly difficult. A taxpayer must offer cash equal to the proceeds that could be generated from a liquidation of the taxpayer's assets plus the net present value of a five-year installment agreement. The taxpayer obviously does not have available cash, so an outside source must fund the offer; (ii) the IRS takes the taxpayer's tax refunds for all tax years up through and including the year in which the offer is accepted; and (iii) the filing of an offer stays the statute of limitation on collection while the offer is pending (and if the offer is accepted and the taxpayer subsequently does not fulfill the underlying contractual obligation) plus the IRS receives an additional 30 days to collect. In the meantime, interest continues to run on the outstanding tax liabilities..04 Bankruptcy Code remedy: Chapter 7. Chapter 7 works best to discharge unsecured income tax liabilities, regardless of size, for which (i) the statute of limitation on assessment for the underlying tax year has run and (ii) the liability was not (A) assessed within the last 240 days nor (B) the subject of an offer in compromise or a collection due process appeal. It provides no relief for relatively fresh tax liabilities. It provides no relief for the 6672 responsible person penalty, regardless of assessment date. It provides no relief from secured tax debt. As compared to an offer in compromise, the filing of a Chapter 7 petition presents several advantages including (i) payments above asset liquidation value are not required; (ii) if available, Bankruptcy Code exemptions are larger than the Tax Code exemptions used by the IRS for computing an offer; and (iii) the bankruptcy estate is only entitled to the taxpayer's tax refund to the extent the refund accrues prepetition (and maybe not even then if the taxpayer can claim the refund exempt). Disadvantages include (i) relief against unsecured debt that is limited in scope; and (ii) no relief against secured debt. cchch1a.wpd -7-
.05 Bankruptcy Code remedy: Chapter 11. Although Chapter 11 can be used by individual debtors regardless of whether they are in business, it remains a relatively unusual remedy for individual taxpayers. Chapter 11 can be used when a taxpayer does not qualify for Chapter 13, cannot age Type 1 obligations into Type 3 obligations, and cannot pay priority taxes under terms and conditions available in an installment agreement..06 Bankruptcy Code remedy: Chapter 13. Because of its $360,475 noncontingent, liquidated unsecured debt and $1,081,400 secured debt limitations, as adjusted for inflation, Chapter 13 works best to discharge "moderate" amounts of debt. It is best used when the taxpayer has some debt problem, unrelated to taxes that needs to be resolved, although there remain some instances when it can be useful for tax debtors. Examples of when Chapter 13 can be useful follow: >Chapter 13 is often used to cure mortgage arrearages and prevent foreclosure. >It is also useful to discharge certain types of divorce debt set forth in 11 U.S.C. 523(a)(15). >It discharges all types of tax penalties. >It discharges debt incurred to pay off nondischargeable tax obligations. >Priority/nondischargeable tax obligations, other than trust fund taxes, can be paid without postpetition interest being incurred. The tradeoff is between the cost of the trustee's fee versus the savings from no interest accruing. >As to secured debt, Chapter 13 effectively caps the payment to the secured creditor at the plan confirmation value and allows the debtor to benefit from postpetition appreciation. >Because a separate taxable entity is not created, the debtor retains tax attributes until the plan is completed and the debt is discharged. cchch1a.wpd -8-
Otherwise, the debtor is better served electing Chapter 7, provided the abuse testing rules of 707(b) do not force the debtor into Chapter 13. 4.07 Bankruptcy Code remedy: Chapter 20. "Chapter 20" is a Chapter 7 bankruptcy followed by a Chapter 13 (or vice versa); no Chapter 20 exists in the Bankruptcy Code. Chapter 20 works when the taxpayer has (i) large nonpriority/dischargeable claims that prevent the use of Chapter 13 and (ii) priority/nondischargeable claims that can be paid in full with interest more easily over the life of a Chapter 13 plan than through negotiations with the IRS over an installment agreement. Section 1328(f)(1), which was added by BAPCPA, prevents a debtor from receiving a Chapter 13 discharge for four years after receiving a discharge in Chapter 7. Post-BAPCPA, Chapter 20s are very rare..08 Pay the Tax. The most obvious remedy is pay the tax. Because people do not, this book ensued. 4 The abuse testing rules are discussed in 910 and 920. cchch1a.wpd -9-