Author Archives: Robert_Schaller

How Do I Serve “Notice” Upon the IRS for a Motion for Contempt for Failure to Respond to a Subpoena, Sanctions, and Compelling Production of Documents?

Battling the IRS can be frustrating to attorneys who do not understand the “notice” requirements that specifically relate to the IRS. Notice rules relating to general creditors are not the same as notice rules relating to the IRS.

So what are the “Notice” rules relating to the IRS and what is the impact of failing to provide proper notice? That issue was addressed in In re Rosen, 542 B.R. 177 (Bankr. E.D.PA 2015).
In Rosen, the Chapter 7 trustee for the debtor’s estate filed a motion against the IRS for contempt for failing to comply with a subpoena, sanctions, and to compel the IRS to produce documents. The IRS resisted. The Trustee served the IRS, but admitted that the trustee failed to serve the U.S. Attorney’s Office or the U.S. Attorney General.

The Rosen court addressed the “Notice” issue relating to the contempt portion of the motion and reserved judgment to a later date on the sanctions issue and document production issue. The court noted that Rule 45(g) of the Federal Rule of Civil Procedure provided the basis upon which the trustee was seeking the contempt order for failure to respond to the subpoena. The court also noted that Rule 45(g) requires proper service as a prerequisite to the entry of an order of contempt. Id. at 179. A party can only be held in contempt for the failure to respond to a subpoena only if that party was property served with that subpoena.

So the obvious question is what constitutes proper service upon the IRS? The answer is found in Rule 7004(b)(5) of the Federal Rules of Bankruptcy Procedure. Rule 7004 provides that service upon the IRS may be accomplished by mailing a copy of the subpoena and any motion to the following parties: (1) the United States attorney for the district in which the bankruptcy case is pending; (2) the Attorney General of the United States at Washington, D.C.; and (3) the IRS.

The Rosen court found that the trustee had failed to serve the subpoena and failed to serve the motion for contempt upon the US Attorney and the US Attorney General. The fact that the IRS had actual notice did not obviate the requirement of proper notice. As such the Rosen court held that the trustee’s failure to comply with the notice requirements of Rule 7004(b)(5) prevented the court from holding the IRS in contempt. The motion for contempt was denied.

Practice Pointer: Attorneys must spend the time to read the Bankruptcy Rules. Relying upon the rules applicable to general creditors is insufficient when dealing with the IRS. The IRS is afforded special protections not afforded to general creditors.
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What Affect Does a Bankruptcy Filing Have Upon an Illinois Real Estate Tax Sale?

The date a bankruptcy case is filed determines a lot.  The filing of the bankruptcy case triggers the implementation of the “automatic stay” provisions of the U.S. Bankruptcy Code.  11 U.S.C. §362(a).  The stay enjoins creditors from taking action to collect debts owed by the debtor.

But how does the automatic stay affect the sale of real estate taxes in Illinois?  The real estate tax sale is actually a multi-step process.  So, the effect of bankruptcy filing depends on the status of the tax sale and whether the buyer is aware of the bankruptcy filing.

An Illinois real estate tax sale has three parts and the bankruptcy case can be filed before or after these parts.  The first part is the tax sale by the county taxing authority and the purchase by a tax buyer.  The buyer tenders money to the taxing authority.  A bankruptcy filing prior to the sale blocks the county from selling the taxes.  Any sale in violation of the automatic stay would be void.

The second part relates to the redemption period assuming the taxes were sold prior to any bankruptcy case.  A bankruptcy filing during the redemption period would not void the sale. However, a bankruptcy filing could effectively extend the redemption period if the homeowner establishes a repayment plan, like a Chapter 13 repayment plan.  The bankruptcy filing does not actually “extend” the redemption period, but it has the same effect.  The redemption period would not expire and the tax buyer would not be allowed to petition the circuit court for a tax deed during a chapter 13 repayment plan if that plan provides for the repayment of the sold taxes.

The third part of the tax sale relates to the petition of the circuit court for the issuance of a tax deed.  A bankruptcy filing after the issuance of the tax deed would not affect the homeowner’s rights because the homeowner would have already lost all legal rights to the property prior to the bankruptcy filing.  In general, a bankruptcy filing stops future action against the bankruptcy filer and preserves the status quo; a bankruptcy filing does not reverse a tax sale or the issuance of a tax deed.

But the bankruptcy court in In re Wilson, 536 B.R. 218 (Bankr. N.D.IL 2015)(Black, J.) had to decide what impact a bankruptcy filing had upon the issuance of a tax deed by an Illinois circuit court when the issuance occurred AFTER a bankruptcy filing but WITHOUT the tax buyer knowing a bankruptcy case was filed.  There, the tax buyer was never informed of the bankruptcy case until after the circuit court had issued the deed.  Both the debtor and the mortgage lender knew of the bankruptcy filing; neither notified the tax buyer.  Consequently, the tax buyer never filed a motion to “lift or remove” the automatic stay prior to petition the circuit court for the tax deed— a motion that the court would have certainly granted.

The Wilson tax buyer filed a motion to “annul” the automatic stay pursuant to 11 U.S.C. §362(d) after the buyer discovered the bankruptcy filing.  The buyer stated that the buyer had no knowledge of the bankruptcy filing prior to the tax deed issuance despite taking steps to investigate.  The court noted that it would be inequitable to punish the tax buyer who acted in good faith while helping the mortgage lender who failed repeatedly to notify the buyer of the bankruptcy filing.  The Wilson court conducted an exhaustive study of the equities between the parties before granting the tax buyer’s motion to annul the automatic stay.  The court also noted that the battle was between the tax buyer and the mortgage lender with the homeowner taking no position.

Practice Pointer:   People who file bankruptcy should make efforts to notify ALL creditors and people who hold adverse interests in any property of the bankruptcy filer.

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How Does a Bankruptcy Filing Affect the Sale of Delinquent Real Estate Taxes?

An owner of real property receives protection from creditors immediately upon filing a bankruptcy case pursuant to 11 U.S.C. §362(a), which provides an “automatic stay” or injunction against creditors’ actions against the owner and the owner’s property.  As to real property, the automatic stay prohibits mortgage lenders from foreclosing on delinquent mortgage notes, and it prohibits governmental taxing authorities from selling any delinquent real estate taxes without leave of court.

An order granting relief from the automatic stay is typically granted in a bankruptcy case if the secured party is not receiving adequate protection, or the owner has no equity in the property and the property is not necessary for an effective reorganization. See 11 U.S.C. §362(d).

But what do taxing authorities do about delinquent taxes when a homeowner files bankruptcy?  It depends when the bankruptcy case was filed in relation to the sale of the delinquent taxes.  First, let’s assume a sale is imminent but did not occur prior to the bankruptcy filing, then let’s assume a sale occurred prior to the bankruptcy filing.

Imminent Sale:  The filing of a bankruptcy case automatically prohibits the sale of the delinquent real estate taxes.  In a Chapter 7 case, the taxing authority typically stands-down and postpones the tax sale  until after the bankruptcy case is concluded.  The taxing authority could file a motion to lift the automatic stay to allow the tax sale, but typically does not file such a motion because of the cost to do so.  A Chapter 7 case typically lasts only 100 days or so.  Thereafter, the taxing authority thereafter conducts the tax sale.

A Chapter 13 case is different because it could last 5 years.  The filing of the Chapter 13 stays the sale of the delinquent real estate taxes just like a Chapter 7 filing.  However, the owner of the real estate must make a decision whether the owner wants to retain the real property or surrender it.  If surrendering the real estate, the owner’s Chapter 13 plan should expressly provide for the surrender of the real estate pursuant to 11 U.S.C. §1325(a)(5)(C) and treat any secured creditor’s deficiency claim as an “unsecured” claim by reason of the surrender.  If retaining the real estate, then the owner’s Chapter 13 plan should provide to cure mortgage arrearage and maintain the mortgage payments, and provide for the full repayment with interest of any delinquent real estate taxes.

Post Sale: The issues are more complicated when a real estate owner files a bankruptcy case after the delinquent real estate taxes have already been sold.  Some states allow an owner to “redeem” the sold real estate taxes within a certain statutory time period.  The Bankruptcy Code allows a Chapter 7 trustee to exercise the homeowner’s redemption rights by paying the delinquent taxes (plus interest) provided the bankruptcy case was filed prior to the redemption period expiring.  Similarly, the Chapter 13 bankruptcy laws allow the home owner to repay the sold real estate taxes over the 5 year period provided the bankruptcy case was filed prior to the redemption period expiring.  Unfortunately, a homeowner cannot save real estate sold for delinquent real estate taxes by filing bankruptcy after the redemption period has expired.

Violating the Automatic Stay:  Sometimes a real estate tax buyer who properly purchased delinquent real estate taxes unknowingly violates the automatic stay by foreclosing a homeowner’s equity of redemption despite a bankruptcy filing.  Such was the case in In re McCrimmon 536 B. R. 374 (Bankr. D.MD. 2015). The tax purchaser bought the delinquent real estate taxes before the homeowner filed bankruptcy.  There was no automatic stay violation at the time of purchase because the bankruptcy case had not yet been filed.  Maryland law required the tax purchaser to give certain notice to the property owner and lienholders at least two months prior to filing an action to foreclose the right of redemption.  The tax purchaser conducted a title search and gave proper notice to the owner and known lienholders prior to filing the foreclosure action in the county court.

Later, the McCrimmon homeowner filed bankruptcy but failed to provide any notice to the real estate tax purchaser.  Subsequently, the tax purchaser filed suit in the county court and foreclosed the homeowner’s right of redemption in accordance with Maryland law.  The mortgage lender objected to the tax purchaser’s foreclosure because it violated the Bankruptcy Code’s automatic stay protections because the foreclosure occurred after the bankruptcy filing and without leave of the bankruptcy court.

The tax purchaser filed a motion to “annul” the automatic stay.  The McCrimmon court granted the tax purchaser’s motion because: (1) the tax purchaser was not noticed and had no actual or constructive knowledge of the bankruptcy filing; (2) the court would have granted a motion to lift the automatic stay had the tax purchaser filed such a motion prior to the foreclosure sale; and (3) the equities favor the tax purchaser because the financial loss to the purchaser by denying the motion to annul far outweigh the financial loss to the mortgage lender by granting the motion to annul.  Therefore, the court annulled the automatic stay so that it had no effect upon the tax purchaser’s foreclosing of the homeowner’s right of redemption.

Practice Pointer:  An individual who files bankruptcy should give notice of the bankruptcy filing to all creditors, including a real estate tax purchaser.  Creditors who violate the automatic stay protections could “annul” the stay if the equities are in their favor.  This is a factual determination.  Annulling the automatic stay would not have occurred in the McCrimmon case had the tax purchaser been given notice of the bankruptcy case and chose to ignore that notice.

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Can the IRS Intercept a Tax Refund to Pay Non-Tax Debts Owed to Other Federal Agencies?

Absent bankruptcy, the federal Treasury Offset Program (“T.O.P”) allows the IRS to offset a non-tax debt owed by a taxpayer to a federal agency against a federal income tax refund owed to the taxpayer.  See 26 U.S.C. §6402.  The right of offset (aka “setoff”) allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making party A pay party B when party B owes party A.

The IRS’ Treasury Offset Program authorizes the Secretary of the Treasury to intercept a taxpayer’s tax overpayment and apply it to preexisting debts.  Section 6402(a) of the US Tax Code provides that the Treasury “may” credit a taxpayer’s income tax overpayment against any tax liability.  Whereas, §6402(d) provides that Treasury “shall” credit a taxpayer’s income tax overpayment against a non-tax debt owed to another federal agency other than the IRS.

However, a taxpayer objected to the IRS intercepting a tax refund in the bankruptcy case of In re Addison, 533 B.R. 520 (Bankr. W.D.VA 2015).  There, the taxpayer argued that the US Bankruptcy Code’s automatic stay provisions of 11 U.S.C. §362(a)(7) prohibited the IRS from offsetting the tax refund against the non-tax liability owed by the taxpayer to the US Department of Agriculture, which related to a mortgage foreclosure deficiency.  The IRS countered and argued that §362(a)(7) did not apply because it was superseded by 11 U.S.C. §362(b)(26)’s negation of the automatic stay for setoffs by the IRS.

The Addison court rejected the IRS’ argument and held that §362(b)(26) did not apply to the facts of this case because §362(b)(26) only applied when the IRS was setting off tax debts owed to the IRS.  In the Addison case, the IRS was setting off non-tax debts owed to the US Department of Agriculture.  Specifically, the court stated §362(b)(26) constrains the reach of the automatic stay by excepting from violating the automatic stay the setoff under applicable nonbankruptcy law of an income tax refund…against an income tax liability.  (emphasis added).

Practice Pointer:   The IRS has broad tax intercept powers to collect debt on behalf of the federal government.  However, these powers are not unlimited.  In the bankruptcy concept, the IRS has the power to intercept tax refunds to offset tax liability relating to a taxable year that ended before the bankruptcy filing date, but the IRS does not have the power to intercept tax refunds to offset non-tax liability owed to other departments of the US Government.

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Can a Taxpayer Discharge Loan Debt Incurred to Pay an Otherwise Non-Dischargeable Tax Debt?

Yes and no, depending on what type of bankruptcy case is filed.  Sometimes a taxpayer has a tax debt that the taxpayer cannot afford to pay, but it cannot be discharged in bankruptcy because of the dischargeability prohibition of 11 U.S.C. §523(a)(1).  So, one strategy is for that taxpayer to obtain a bank loan to acquire capital and then tender the bank loan funds to the taxing authority to pay off the tax debt.  Then, that taxpayer files bankruptcy in an attempt to discharge the non-tax bank debt.

Such a taxpayer who files chapter 13 bankruptcy would have an easy time discharging the bank debt as long as the taxpayer waits a sufficient period of time.  The Bankruptcy Code does not expressly prohibit the Chapter 13 discharge of debts incurred to pay non-dischargeable tax debts.  However, an immediate bankruptcy filing after acquiring the bank loan would trigger issues of bad faith and fraud with a bank alleging the taxpayer had no intention of ever repaying the bank loan.  See 11 U.S.C. §§523(a)(2) or (a)(4). So a taxpayer should wait a period of time before filing bankruptcy, and make the required monthly payments on the loan until the bankruptcy filing to show good faith and act as a prophylactic.

A taxpayer who files chapter 7 bankruptcy would be out of luck and find non-dischargeable pursuant to 11 U.S.C. §§523(a)(14) or (a)(14A) the bank debt incurred to pay off the tax debt.  These Bankruptcy Code sections except from Chapter 7 discharge debt incurred to pay a non-dischargeable tax owed to the United States or any other governmental unit.

These issues were addressed in Brown v. Link (In re Link), 2015 Bankr. LEXIS 3248 (Bankr. E.D.MO 2015).  In Link, a restaurant seller owed delinquent state sales tax at the time the restaurant was sold.  The seller sold the business to the buyer (and the buyer ultimately filed Chapter 7 bankruptcy) for an amount sufficient to pay the seller’s state sales tax obligation.  The buyer did not have sufficient capital so the buyer secured a loan.  The lender tendered funds to the buyer in the form of three checks: (1) a check made payable to the state sales taxing authority in the exact amount of the sales tax debt owed by the seller; (2) a check made payable to the state sales taxing authority in an amount the buyer was required to pay the state taxing authority as a bond for prospective sales taxes; and (3) a check made payable to the buyer for additional capital. Ultimately the restaurant failed and the buyer filed bankruptcy seeking to discharge the loan provided by the lender that had been used to pay money to the state sales taxing authority.

The first issue the Link court had to address was whether the 11 U.S.C. §523(a)(14A) non-dischargeability exception applied to loans incurred to pay tax debts owed by someone other than the person filing bankruptcy.  In Link, this issue related to the buyer’s loan incurred to pay the state sales tax owed by the seller.  The Link court held that the 11 U.S.C. §523(a)(14A) non-dischargeability exception applied to the payment of all non-dischargeable tax debts and was not limited to just the tax debts owed by the person filing bankruptcy.  Therefore, the buyer’s loan was deemed non-dischargeable because the court found a direct connection between the loan incurred and the immediate application of those funds to seller’s tax obligations.

The second issue the Link court had to address was whether the 11 U.S.C. §523(a)(14A) non-dischargeability exception applied to loans incurred to pay a bond for prospective sales taxes.  The court found that buyer’s use of the loan to pay the sales tax bond resulted in the loan being rendered non-dischargeable.  This issue appears more complicated than the first issue and the court’s analysis is debatable.  The Link court interpreted expansively the non-dischargeability statute’s language of “a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.” 11 U.S.C. §523(a)(1) incorporating 11 U.S.C. §507(a)(8)(C).  This interpretation appears to be overly expansive and subject to an appellate attack because the buyer’s bond was not a “tax,” but merely collateral to be used by the state sales taxing authority in the event the buyer fails to pay to the taxing authority the required sales tax in the future.  If the buyer pays the appropriate sales taxes in the future, then the bond would be returned to the buyer.  As such, the bond may be interpreted by an appellate panel as not “a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.”  11 U.S.C. §523(a)(1) incorporating 11 U.S.C. §507(a)(8)(C).  Under this alternative interpretation, the loan proceeds used to pay the bond would not be deemed a payment of a “tax” and would therefore be dischargeable. But, the buyer never appealed the decision so the issue has to wait for another case.

Practice Pointer:   A taxpayer should file Chapter 13 bankruptcy instead of Chapter 7 bankruptcy if that taxpayer is attempting to discharge a loan incurred to pay otherwise non-dischargeable taxes owed to the IRS or another taxing authority.  Chapter 7 is a poor choice.  Instead, a Chapter 13 bankruptcy with a limited dividend to unsecured creditors would be a better strategy.

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Can a Merchant Discharge Unpaid Sales Taxes by Filing Bankruptcy?

We all have paid sales taxes when purchasing consumer items.  But where does that money go?

In most states, a merchant selling consumer products is required to collect sales tax from customers and hold that money in trust for the government.  Periodically, the merchant is required to report the amount of sales taxes collected and to tender the tax money to the government.

However, some merchants fail to tender the money to the government when business is bad and use the trust fund money as a cash infusion to keep the business afloat.  It’s a terrible idea from a bankruptcy attorney’s point of view, but merchants struggling to keep their doors open sometimes grab any life-line they can reach.

Such was the case in Cooper v. Miss. Dep’t of Revenue (In re Cooper), 2015 Bankr. LEXIS 3261, (Bankr. S.D.MS 2015).  Cooper was audited by the Mississippi Department of Revenue for a three year period and assessed almost $60,000 in unpaid sales taxes.  MDOR filed a lien to secure its claim and started collection efforts against Cooper.

Two years later, Cooper responded by filing Chapter 13 bankruptcy and then initiated an adversary proceeding alleging the sales tax debt was dischargeable.  However, the court noted that Cooper failed to site any Bankruptcy Code sections or case law supporting Cooper’s position. MDOR filed a motion for summary judgment asserting that there are no factual issue in dispute and MDOR is entitled to a judgment that the sales tax debts are non-dischargeable.  MDOR’s claim had increased with interest to approximately $70,000.

The Court granted MDOR’s motion and held that the sales tax debts were non-dischargeable pursuant to 11 U.S.C. §§523(a)(1)(A) and  507(a)(8)(A).  The court’s reasoning for nondischargeability was limited to a one paragraph declaration.  Interestingly, MDOR did not allege that the taxes were nondischargeable pursuant to § 507(a)(8)(C), which would have been harder to discharge.  But MDOR’s attack on a  §507(a)(8)(A) basis opened a dischargeability door for Cooper to walk through, but Cooper failed to take advantage of this strategic opening and had to suffer the consequences of having $70,000 worth of tax debts rendered non-dischargeable.

Practice Pointer:   The taxpayer missed an opportunity to discharge the sales tax debt.  According to the Cooper court, the sales taxes were a §507(a)(8)(A) tax.  This type of debt could have been discharged if the taxpayer had waiting the required time periods set forth in 11 U.S.C. §§523(a)(1)(A) and  507(a)(8)(A).  Cooper should have considered before filing bankruptcy  the 3-year due date rule, 2-year filing date rule, and the 240-day assessment rule.  But Cooper failed to time the filing correctly, which resulted in Cooper not discharging the $70,000 claim.  Cooper should have made the investment and paid a little more to acquire expert legal advice.

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Can a Bankruptcy Trustee Force the IRS to Surrender Trust Fund Taxes Paid by a Bankruptcy Payroll Company?

It is not uncommon for a for-profit corporation to outsource payroll services to an independent payroll company (“Payroll Provider”) to help administer payroll tasks.  A corporation typically advance funds to the Payroll Provider near the end of a payroll cycle, which are in turn used by the Payroll Provider to pay wages to the corporation’s employees and pay corresponding trust fund obligations to the various taxing authorities.

But what happens when the Payroll Provider files bankruptcy within 90 days of paying trust fund obligations to the IRS?  The issue is one of “preferential transfer.”  This issue was addressed in Slobodian v. United States of America, 533 B.R. 126 (Bankr. M.D.PA 2015), where the Payroll Provider paid $32,297 to the IRS within the period 90 days prior to the Payroll Provider filing bankruptcy.

In Slobodian, The Chapter 7 trustee filed an adversary complaint against the IRS alleging that the IRS payment was a preferential transfer because it was made within 90 days of the bankruptcy filing.  The trustee sought disgorgement of the $32,297 so that the funds could be redistributed to all creditors according to their statutory rights.

The Slobodian court ruled that in order to disgorge a purportedly preferential transfer, a trustee must demonstrate a (1) transfer of an interest of the debtor in property (2) to or for the benefit of a creditor (3) for or on account of an antecedent debt owed by the debtor, and (4) made while the debtor was insolvent.  11 U.S.C. §547(b).

So the big issue for the Slobodian court to determine was whether the $32,297 payment constituted a “transfer of an interest of the debtor in property.”  The IRS argued that the Payroll Provider never possessed an interest in the property for preference action purposes, and instead held the transferred funds in trust, to be transmitted to the United States pursuant to the Payroll Provider’s payroll service agreement with the corporation that provided the funds to the Payroll Provider.  The IRS asserted that the funds were held in a special statutory trust for the United States pursuant to 26 U.S.C. §7501(a), which states “Whenever any person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the United States, the amount of tax so collected or withheld shall be held to be a special fund in trust for the United States.”  The special trust applies to Social Security, Medicare, and income taxes that Congress requires employers to withhold from employees’ paychecks, commonly referred to as “trust-fund taxes.” Id. at 134, citing Begier v. Internal Revenue Service, 496 U.S. 53, 54 (1990).

The Slobodian court agreed with the IRS and found that corporation’s channeling of trust fund taxes through the third-party Payroll Provider did not dilute the protections of the 26 U.S.C. §7501(a) trust.  The corporation tendered the funds to the Payroll Provider which collected the funds pursuant to its payroll services agreement and withheld both trust fund and non-trust fund taxes from the collected funds before ultimately distributing employee paychecks.  Therefore, the Payroll Provider did not own an equitable interest in the property it held in trust for the corporation, and thus the $32,297 payment was not “property of the estate” for purposes of preferential transfers of 11 U.S.C. §547(b).

The IRS was allowed to retain the payment and the corporation received full credit for the trust fund payments.

Practice Pointer: Be careful when dealing with payroll providers.  Perform due diligence on the providers before tendering money to them.  Make sure the funds tendered by the corporation to the payroll service are made from a segregated trust fund account and not from the corporation’s general operating account.  The preferred method would be two separate payments being made to the payroll service: one payment for employees; and one payment for the taxing authorities.  This preferred method would buttress a corporation’s argument that the trust fund payments were tendered to the payroll service in trust as part of a 26 U.S.C. §7501(a) trust fund. It may not be “convenient” but it is following best practices.

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Don’t Trust the IRS’ Advice, it May be Wrong!

What recourse do taxpayers have if they wrongly rely upon the IRS’ bankruptcy advice?  None according to In re Brown, 533 B.R. 344 (Bankr. M.D. FL 2015).  There, taxpayers followed the IRS’ inaccurate bankruptcy advice that resulted in unwanted tax collections, including levies against the taxpayers’ bank accounts and tax refund offsets after the taxpayers’ bankruptcy case concluded.  The Brown court rejected the taxpayers’ theories of laches and estoppel to stop the IRS  because these equitable doctrines could not thwart the clear mandate of the U.S. Bankruptcy Code.  11 U.S.C. §101 et seq. The opinion did not state whether the taxpayers were represented by counsel at the time the IRS gave the advice or, if represented, why the taxpayers did not rely on contrary advice given by the taxpayers’ attorney.

Originally, the Brown taxpayers sought bankruptcy protection for relief from the IRS’ collection efforts initiated prior to the bankruptcy filing.  The taxpayers’ confirmed repayment plan, as amended, provided for the repayment of 100% of the IRS’ non-dischargeable priority tax claims and only a small percentage of the IRS’ non-priority unsecured claims relating to tax penalties (hereinafter, “Penalty Claims”).

Later, the taxpayers experienced problems making the plan payments.  The IRS recommended a strategy urging the taxpayer to file for a “hardship discharge” pursuant to 11 U.S.C. §1328(b) and then resolve the remaining priority debt issue outside of bankruptcy through an offer in compromise.  According to the IRS, this strategy would have allegedly discharged the Penalty Claim.  The taxpayers took the IRS’ advice and concluded the bankruptcy early by obtaining a hardship discharge.

The post-bankruptcy events did not go as planned.  The taxpayers’ offer in compromise was rejected by the IRS and the IRS sought to collect both the priority claim PLUS the Penalty Claim.  After the bank levied the taxpayers’ bank accounts and offset their tax refund, the taxpayers filed action in the bankruptcy court alleging the IRS violated the bankruptcy discharge injunction.

The Brown court had to determine if a hardship discharge under 11 U.S.C. §1328(b) eliminated the IRS’ Penalty Claim since the IRS encouraged the taxpayers to pursue a hardship discharge, and at no time indicated the IRS intended to collect on its Penalty Claim after the hardship discharge.

First, the Brown court understood that the hardship discharge of 11 U.S.C. §1328(b) is more limited in scope than the general discharge of 11 U.S.C. §1328(a).  Of particular importance was the discharge exception relating to tax penalties pursuant to 11 U.S.C. §523(a)(7). Unlike the general discharge of §1328(a) which eliminates tax penalties, the hardship discharge of §1328(b) does not discharge tax penalties relating to government claims for income taxes due within the three years prior to the bankruptcy filing.

Second, the Brown court found that the IRS’ inaccurate advice rendered prior to the entry of the hardship discharge did not affect the dischargeability of the IRS’ Penalty Claim.  The Penalty Claims remained non-discharged.  Therefore, the IRS was not violating the discharge injunction when it levied on the taxpayers’ bank accounts because the IRS’ debts were not discharged when the taxpayers received the §1328(b) hardship discharge.

Practice Pointer: Do not take the IRS’ advice on bankruptcy issues of law. Contact a qualified bankruptcy attorney with extensive experience in income tax dischargeability.  Taxpayers should follow the advice of experienced counsel and not the advice/strategy of the IRS.  Honest taxpayers who follow the IRS’ inaccurate advice could find themselves in deep trouble.  The old adage is true:  You get what you pay for; so don’t take free advice!

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Tax Debts are Dischargeable 3 Years After a Return Due Date Unless Tolled by a Prior Bankruptcy or Other Matter.

Income taxes are dischargeable in bankruptcy three years after the tax return “due date.” 11 U.S.C. §523(a)(1)(A) incorporating 11 U.S.C. §507(a)(8)(A)(i).  But that 3-year period can be extended or “tolled” if the taxing authority was prohibited from collecting against the taxpayer as a result of a pending bankruptcy case.  For example, consider a tax payer who files chapter 13 bankruptcy because he owes significant tax debts and seeks protection from the IRS’ collection efforts, liens, levies, etc. The tax debts owed prior to a bankruptcy filing are scheduled to be repaid in a chapter 13 bankruptcy case; the IRS would be prohibited from collecting against the taxpayer during the life of the chapter 13 because of the automatic stay protections granted to the taxpayer.  If the taxpayer does not complete the full repayment plan, then the case could be dismissed and the IRS would be afforded time to collect those prepetition tax debts, including the 3-year period, plus anytime the taxpayer was in bankruptcy, plus 90 days.  See 11 U.S.C. §507(a)(8)(*).

But what happens if the tax obligations related to tax years ending AFTER the chapter 13 bankruptcy case was filed?  That issue was address in Kolve v. IRS (In re Kolve), 459 B.R. 376 (Bankr. W.D.WI 2011).  In Kolve, a taxpayer’s prior chapter 13 bankruptcy case lasted more than two years.  During those two years, the taxpayer failed to pay the tax obligations coming due after the bankruptcy filing but while the case was still pending.  The prior bankruptcy case was ultimately dismissed and these postpetition tax debts were never paid.

The taxpayer waited just longer than three years after the dismissal of the chapter 13 bankruptcy case to file a chapter 7 bankruptcy case.  The taxpayer sought to discharge the taxes incurred after the filing of the prior bankruptcy case (but while the prior bankruptcy case was still pending).  The taxpayer argued a discharge was appropriate because the tax obligations related to tax returns whose “due date” was more than three years prior to the subsequent bankruptcy filing date. The IRS objected to the discharge stating that the 3-year “due date” period was tolled while the prior bankruptcy case was pending since the tax returns came due while the prior bankruptcy case was active.  The IRS cited the 90-day tolling provision of 11 U.S.C. §507(a)(8)(*).

The Kolve court ruled in favor of the taxpayer.  It found the tolling provision inapplicable because the IRS had not been prohibited by the automatic stay protections from collecting the tax obligations incurred while the prior bankruptcy case was pending. The court distinguished between tax obligations incurred prior to the original bankruptcy case (prepetition taxes) and the tax obligations incurred after the original case was filed (postpetition taxes).  The IRS was estopped from collecting prepetition taxes by the bankruptcy, but was not prohibited from collecting the postpetition taxes.  Therefore, the “tolling” provision that grants the IRS an additional 90 days was not applicable.  The tax debts were deemed dischargeable.

Practice Pointer:   The tolling period appears to be dependent upon the taxing authority being actually prohibited from collecting.  The mere existence of a bankruptcy case is not sufficient.  The taxing authority must be denied the right to exercise its collections rights, including garnishments, liens, and levies.

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Discharge Income Taxes 3 Years After the Due Date.

Taxpayers can discharge income tax obligations by filing bankruptcy three years after the tax return “due date.” 11 U.S.C. §523(a)(1)(A) incorporating 11 U.S.C. §507(a)(8)(A)(i).  The tax return “due date” is the date on or before which the tax return is required to be filed.  For IRS taxes, the filing due date is April 15th following the prior tax year, assuming that date is not a weekend or holiday.

However, the “due date” for bankruptcy purposes changes when a taxpayer requests and receives an automatic extension of the filing due date.  For example, a taxpayer can file IRS Form 4868 “Application for Automatic Extension of Time to File U.S. Individual Income Tax Return.”  This application extends the due date 6 months to October 15th.  In such a situation the “due date” for bankruptcy purposes would be October 15th — even if the taxpayer files the return between the April 15th original deadline and the October 15th extended deadline.  The date of filing is not at issue; the “due date” is the key issue for 11 U.S.C. §507(a)(8)(A)(i) purposes.

Similarly, the “due date” for state and local taxes could also be extended automatically even without the taxpayer submitting a request to the state and local taxing authorities.   Some states automatically extend the due date for the state tax returns if a taxpayer requests and receives an extension of the federal tax return due date.  Under these circumstances, the “due date” for bankruptcy purposes for those state and local taxing authorities would be the extended due date.

Practice Pointer:   Best practices requires a careful review and calculation of the tax return “due date” to determine if a tax obligation is dischargeable in bankruptcy. A matter of a single day could result in an otherwise dischargeable tax debt being rendered non-dischargeable.

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Can Income Taxes be Eliminated if the IRS Still Has the Right to Assess a Deficiency?

No, income taxes cannot be discharged or eliminated in bankruptcy if the taxing authority still has the right to assess a tax.  Section 523(a)(1)(A) of the Bankruptcy Code identifies certain types of income taxes that are non-dischargeable in bankruptcy by incorporating §507(a)(8)(A) of the Bankruptcy Code.  Section 507(a)(8)(A) excepts from discharge any income taxes that are assessed within 240 days of the bankruptcy filing, or are assessable under applicable non-bankruptcy law after the bankruptcy case is filed.

The US Court of Appeals for the Seventh Circuit addressed this issue in U.S. v. Frontone, 383 F.3d 656 (7th Cir. 2004).  In Frontone, a taxpayer had filed a tax return and paid the tax owed as required by the IRS Code.  However, the IRS made an error and wrongly tendered a tax refund to the taxpayer.  The IRS later realized its error and issued a supplemental assessment for the deficiency caused by the tax refund.  The IRS compounded the error by making another error—namely, issuing a supplemental assessment without issuing a notice of deficiency.

The taxpayer filed bankruptcy in an effort to discharge the tax debt caused by the tax refund.  The Frontone court denied the taxpayer’s quest for a discharge because the tax obligation was assessable at the time the bankruptcy case was filed. First, the court found that the IRS’ supplemental assessment was in error because it had not followed a “notice of deficiency.”  But that did not save the taxpayer because the court found that the IRS eventually filed the required notice of deficiency within the time period allowed as provided by the IRS Code (even if it was after the bankruptcy filing).  Therefore, since the notice of deficiency was finally issued correctly, the Frontone court found the tax refund obligation non-dischargeable because the tax debt was “assessable” on the date the bankruptcy case was filed.

Practice Pointer:   Best practices requires a careful analysis of the tax filing deadlines and the Bankruptcy Code’s statutory waiting periods.  Taxpayers must wait to file bankruptcy at least 240 days after the IRS assesses the tax, AND wait beyond the statutory assessment period if the IRS has not yet assessed a tax so that the tax becomes non-assessable.

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Taxpayers can discharge income tax liability relating to late-filed returns by filing Chapter 7 bankruptcy.

A Chapter 7 bankruptcy general discharge eliminates a debtor’s obligation to pay debts.  11 U.S.C. §727.  However, income tax debts relating to an unfiled tax return are excepted from the general discharge and survive the bankruptcy.  11 U.S.C. §523(a)(1)(B)(i).  The issue in Biggers was whether an IRS Form 1040 can be considered a “return” for bankruptcy purposes when filed after the due date and after the IRS unilaterally assessed a tax.

The Biggers court noted that courts across the country are divided regarding the issue of discharging tax obligations relating to late-filed tax returns.  Some courts have concluded that a late-filed tax return can never be a “return” for bankruptcy purposes solely because the return was filed after the tax filing deadline – even one day late.  See, e.g., In re Fahey, 779 F.3d 1 (1st Cir. 2015).  These courts rely on the Bankruptcy Code’s definition of “return” contained in 11 U.S.C. Section 523(a)(*), which states the term “return” means a return that satisfies the requirements of “applicable nonbankruptcy law”-including applicable filing requirements.

However, the Biggers court reached a different conclusion and rejected Fahey’s rational and held that a late-filed return can be deemed a “return” for bankruptcy purposes if it meets the definition of “return” as set forth in Beard v. Commissioner, 82 T.C. 766, 1984 WL 15573 (1984), affirmed 793 F.2d 139 (6th Cir. 1986).  The Beard test determining whether an IRS Form 1040 is a “return” has four prongs: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law.   

The Biggers court agreed with those decisions that define the phrase “applicable non-bankruptcy laws” of 11 U.S.C. Section 523(a)(*) as the pre-BAPCPA Beard test and found a Form 1040 is a “return” if it satisfies the Beard test. The court rejected the idea that the reference to “applicable non-bankruptcy laws” relates narrowly to the filing deadline imposed by the taxing authority per statute.

The Biggers court then applied the Beard test, noting that the taxpayers had filed multiple returns after the filing deadline and after the IRS had already assessed the tax.  The court found that the late-filed returns served no purpose on all but one return because the tax liability disclosed on the late-filed return was less than the amount assessed by the IRS and therefore did not “represent an honest and reasonable attempt to satisfy the requirements of the tax law,” as required by the fourth prong of the Beard test.  However, the court allowed the discharge of income tax relating to the one late-filed return that disclosed liability greater than the amount assessed by the IRS.  The Court allowed the discharge as to the tax liability that exceeded the IRS’ assessed liability that return.  Although not addressed in the opinion, it appears the Biggers court would have discharged all of the tax liability had the returns been filed after the filing deadline but before the IRS had assessed the tax.

When are Income Taxes Assessed by the Government?

Income taxes are dischargeable by filing bankruptcy if the taxpayer waits more than the amount of time set forth in the Bankruptcy Code.  One of the requirements is that the taxpayer must wait to file bankruptcy more than 240 days after the date the taxing authority “assesses” the tax.  See 11 U.S.C. §523(a)(1) incorporating §507(a)(8)(A)(ii).

But when are income taxes deemed “assessed” such that the 240-day clock starts ticking? This issue was addressed in Harnden v. United States of America (In re Harnden), Nos. 08-B-71909, 10-A-96039 (Bankr. N.D.IL 2011), where the IRS had audited the taxpayer and determined that the taxpayer had underreported his income by about $30,000.  The IRS sent the taxpayer Form 4549 (Income Tax Examination Changes) requesting that the taxpayer agree to the proposed increase in tax and waive any appeal rights.  The taxpayer signed the form in August of 2006, which stated “I give my consent to the immediate assessment and collection to any increase in tax and penalties.” The IRS, however, did not officially assess the tax until February of 2008.  The taxpayer filed the bankruptcy case in June of 2008, less than 240 days after the IRS had officially assessed the tax.

The Harnden court rejected the taxpayer’s argument that the IRS had effectively assessed the tax upon the taxpayer signing and returning the Form 4549 Income Tax Examination Changes.  The court found that neither the notice the IRS sent nor the taxpayer’s signature and return of the tax examination changes form constituted an “assessment” of the additional tax.

The Harnden court found that the assessment of federal income tax is “made by recording the liability of the taxpayer in the office of the Secretary [of the Treasury] in accordance with rules or regulations prescribed by the Secretary.” 26 U.S.C. §6203.  Those regulations delegate authority to “assessment officers” and state that the “assessment shall be made by an assessment officer signing the summary record of assessment. … The date of the assessment is the date the summary record is signed by an assessment officer.” 26 C.F.R. §301.6203-1.

Practice Pointer:   Best practices warrant obtaining proof from the taxing authority of the official assessment date.  For IRS debt, tax professionals must obtain copies of the IRS’ account transcript for each year that a taxpayer desires to discharge a tax obligation.  The tax transcript can assure counsel that the taxpayer has waited the appropriate time to pass the various time sensitive rules.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Does a Bankruptcy Filing Stop the IRS from Levying Assets? 

Yes, filing bankruptcy immediately stops the IRS from levying assets or even threatening to levy assets while the bankruptcy case is pending.  Section 362 of the Bankruptcy Code provides that a bankruptcy filing immediately protects a taxpayer by an automatic injunction called the “automatic stay” from any act by a taxing authority to collect, assess, or recover a claim against the taxpayer that arose before the bankruptcy case was filed. 11 U.S.C. §362(a)(6). The conduct prohibited ranges from that of an informal nature, such as by telephone contact or by dunning letters, to more formal judicial and administrative proceedings.

In the IRS context, the automatic stay prohibits the IRS from sending a Notice of Intent to Levy and a Notice of Levy. However, the Bankruptcy Code does not prohibit all communications by the IRS.  Despite the fundamental importance of the automatic stay, Congress provided taxing authorities an exception to the automatic stay provision for “(A) an audit by a governmental unit to determine tax liability; (B) the issuance to the debtor by a governmental unit of a notice of tax deficiency; (C) a demand for tax returns; or (D) the making of an assessment for any tax and issuance of a notice and demand for payment of such an assessment. See 11 U.S.C. §362(b)(9).

The §362(b)(9) exception has its own limitations and is narrowly construed.  The IRS may be permitted to make an assessment and a demand for payment. However, the IRS cannot couple that demand for payment with a Notice of Levy or other collection effort, or a Notice of Intent of Levy or other threat of a collection effort, including IRS pamphlets entitled “Understanding the [IRS] Collection Process (IRS Publication 954).

The limits of a §362(b)(9) exception was addressed recently in the non-IRS case In re Gonzalez, 532 B.R. 1 (D. PR 2015). The Gonzalez court had to determine if the Treasury Department of Puerto Rico violated the automatic stay by sending a debtor a “Final Notice” regarding the taxpayer’s prepetition income tax debt. That notice also included an assertion that the law empowers the taxing authority to use collection steps like wage garnishments and asset levies. The Gonzalez court rejected the taxing authority’s argument that such communications are excepted from the automatic stay by §362(b)(9).  Instead, the Gonzalez court ruled that the threat of collection efforts is outside the creditor protection of §362(b)(9) and is an automatic stay violation of 11 U.S.C. §362(a)(6).  The tax authority’s actions were enjoined and the violation subjected the taxing authority to sanctions, costs, and attorney’s fees.

PRACTICE POINTERS: A tax professional should recommend a taxpayer seek the advice of a bankruptcy attorney whenever the IRS or other taxing authorities are threatening collections action like levies and garnishments.  The automatic stay protections afforded by the Bankruptcy Code give taxpayers breathing room to orderly address the tax collection issues jointly with the tax professional and bankruptcy attorney.  The automatic stay stops the IRS from collecting, including levies and garnishments.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Are Excise Taxes Dischargeable in Bankruptcy? 

Excise taxes assessed against an individual are dischargeable in a Chapter 7 case if the taxpayer waits three years to file bankruptcy.  The waiting period begins on the date of the transaction that incurs the excise tax if the taxpayer is not required to file a tax return reporting the excise tax.  However, the waiting period begins on the date of the tax return “due date” if the taxpayer is required to file a tax return reporting the excise tax transaction.

The excise tax is deemed a “priority” tax within the first three years of the waiting period pursuant to  11 U.S.C. §507(a)(8)(E) and rendered nondischargeable pursuant to 11 U.S.C. §523(a)(1)(A).  But the excise tax transforms into a “general unsecured” tax after the three year waiting and becomes dischargeable period pursuant to 11 U.S.C. §§727(a) and 1328(a).

So, the individual taxpayer who waits the three years can obtain a Chapter 7 discharge of the excise tax without paying any money to the taxing authority pursuant to 11 U.S.C. §727(a).  However, filing one day too early would cause the excise tax to be a non-dischargeable priority debt pursuant to 11 U.S.C. §523(a)(1)(A) incorporating 11 U.S.C. §507(a)(8)(E).

Similarly, the individual taxpayer who waits the three years can obtain a Chapter 13 discharge of the excise tax debt pursuant to 11 U.S.C. §1328(a) by paying only the percentage of the general unsecured debt required by the “liquidation analysis” of 11 U.S.C. §1325(a)(4).

Excise taxes assessed against a corporation are never dischargeable by filing Chapter 7 since corporations cannot receive a Chapter 7 discharge.  Similarly, corporations cannot receive a Chapter 13 discharge because they are not eligible to file Chapter 13.  However, a corporation could file a Chapter 11 case and pay less than the full amount of the excise tax if the corporation waits longer than the three year waiting period.

The dischargeability of an excise tax by an individual was addressed in In re Carpenter, 519 B.R. 811 (Bankr. D.MT 2014).  There, a corporation failed to pay required unemployment insurance taxes. The state taxing authority then assessed the tax against the corporate president as a “responsible party” because the president failed to cause the unemployment taxes to be paid.

The Carpenter court identified the issue as whether a corporate president’s personal liability for the corporate excise tax retains the status of “excise tax” when applied to the president individually.  The Court noted that all parties stipulated that the corporation’s obligation to pay the unemployment insurance tax was an “excise” tax. However, the president argued his tax obligation under the “responsible party” rule does not constitute an excise “tax” and is therefore not a priority debt.  Id. at 813.

Before ruling the court quoted Collier on Bankruptcy as stating the “first step in determining whether a claim is entitled to priority is determining whether the claim asserted by a governmental entity is a tax or is another type of obligation.”  4 Collier on Bankruptcy Sec 507.11[6].  The court determined that the obligation owed by the president as a “responsible party” was a tax.  Then, the court rejected the president’s argument and found that the president’s obligation to pay as a responsible party was an obligation to pay an “excise” tax and thus was a priority debt.  The logic of the opinion is somewhat confusing and could have been challenged on appeal.

PRACTICE POINTERS: A tax professional should analyze whether the obligation imposed by the government is a “tax” or merely a debt.  Any debt would be dischargeable in an individual Chapter 7 bankruptcy.  Any excise “tax” would be nondischargeable within the three year waiting period, but would be transformed into a dischargeable debt after the three year waiting period.

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The IRS Seized the Corporation’s Assets. Can a Corporation File Bankruptcy and Discharge Tax Debts? 

I’m often asked how a corporation can eliminate its tax debts.  Typically, the corporation has withheld taxes from its employees’ paychecks but has not tendered these “trust fund taxes” to the IRS or state taxing authority.  These withheld funds are referred to as “trust fund taxes” because the employer withheld the money “in trust” for the benefit of the IRS or other taxing authority.

An employer who is struggling financially uses the trust fund taxes as a source of hard currency, much like it would if granted a bank loan.  An employer hopes the use of the trust fund taxes would defuse a business crisis or at least keep the business afloat until brighter days (entrepreneurs always see a brighter tomorrow).  The problem is the IRS is not a lender and did not voluntarily give the employer the money —and certainly has not granted the employer authorization to use the trust fund taxes.

The IRS is typically aggressive in collecting the trust fund taxes.  The IRS can intercept tax refunds, lien, levy, seize, and exercise other collection tactics.  Seizure of the corporation’s asset could terminate the business.  For example, what would a restaurant owner do if the president arrived at the restaurant one morning to find the IRS had seized all the tables, chairs, refrigerators, freezers, etc.? Panic of course!

So what is the corporation to do?  Call its lawyer of course!  But there is only so much a lawyer can do in such an emergency.

The corporation is generally not in a position to repay the IRS the full amount of the trust fund taxes in a quick lump-sum payment so that the assets are returned.  Lawyers can contact the IRS and try to negotiate an installment agreement or an offer-in-compromise— but that takes time and the IRS would be in no hurry to relieve the taxpayer’s pressure by returning the assets.  An emergency bank loan would be nice, but that is not realistic because of the pending tax obligation and the fact that the restaurant is not operating since the IRS seized the tables, chairs, refrigerators, freezers, etc.

So bankruptcy becomes the obvious solution.  Chapter 13 is not available because the tax debt is owed by the corporation and Chapter 13 is available only to individuals.  Chapter 11 is a great option. Filing the Chapter 11 bankruptcy case would grant the corporation with the “automatic stay” protections of the US Bankruptcy Code.  The attorney would contact the IRS to negotiate a return of the assets for the company’s promise to pay adequate protections payments to the IRS going forward.  If negotiations are unsuccessful, then the court should rush to the courthouse to file an adversary proceeding to force the IRS to return the assets… again, the company would have to provide the IRS adequate protection.  But at least the company could return to regular business operations.

Some clients ask if the taxes could be discharged by filing Chapter 7 bankruptcy without the need to pay any adequate protection payment to the IRS. The answer is NO.  That strategy was tried by a convenience store operating in Senatobia, Mississippi in the case of In re Sarfani, Inc., 527 B.R. 241 (Bankr. N.D.MS 2015).  In Sarfani, the company attempted to discharge unpaid sales taxes collected from customers as “trust fund” taxes.  The court rejected the company’s attempt to discharge the taxes because Sarfani, Inc. was a corporation and Chapter 7 bankruptcy discharges are only available to individuals (human) and not corporation, partnerships, LLCs, LLPs, trusts, etc.  11 U.S.C. §727(a)(1).  So, Chapter 11 would be the best bet.

PRACTICE POINTERS: The best tax planning is advanced tax planning. Bankruptcy lawyers are frequently contacted in emergencies after the IRS collectors have struck and struck hard—shuttering a business.  The IRS can be agreeable if the company negotiates before the issue comes to a boil.  But once the IRS collectors have taken action a company would typically need court intervention and the bankruptcy protections to survive.  How long can a company survive that is shuttered?  NOT LONG!  Customers find competitors, suppliers and vendors get frightened, and employees quit and find other jobs.  Immediate Chapter 11 bankruptcy protection would be warranted.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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How Does “Innocent Spouse Relief” Protect Taxpayers From IRS Levies and Collections?

Taxpayers who file joint IRS 1040 tax returns are jointly and severally liable for the full tax liability no matter how much or how little they contribute to the total tax.  That liability is not affected by divorce.  Sure, a divorce court could order one party to pay all or part of the joint tax debt, but such an order does not change the fact that each spouse is jointly and severally liable to the IRS.  The IRS can pursue collections against either or both taxpayers no matter how the divorce court shifts responsibility between the joint filers.

What options are available to an ex-wife if the prior years’ joint tax liability really resulted from extraordinarily large income produced by the ex-husband and the ex-husband now refuses or is unable to pay the taxes? You should consider “innocent spouse relief” offered by the IRS pursuant to 26 U.S.C. §6015?

Tax professional must be able to distinguish between two separate scenarios that may offer “innocent spouse relief” to the ex-wife: one good, and one bad.

The good scenario relates to a situation where a tax return was never filed or the filed return understated the true tax liability.  That scenario causes the IRS to assess a tax for the never filed return or assess a tax deficiency for the understated portion of the tax liability.  Section 6015 of the Internal Revenue Code grants the IRS authority to eliminate the assessed tax deficiency under the “innocent spouse relief” program when the innocent spouse had no knowledge of the understatement and had no reason to know of the understatement.  A perfect example is a wife of a self-employed home-remodeler and the wife has no involvement with the business and no knowledge that the home-remodeler underestimated the tax liability on the joint tax return.

The bad scenario relates to a situation where a tax return was properly filed and did NOT understate the tax liability on the return; the tax liability exists because the taxpayers did not save sufficient funds to pay the tax liability.  That was the scenario in In re Mikels, 524 B.R. 805 (Bankr. S.D. IN 2015).  In Mikels, an ex-spouse applied to the IRS for innocent tax relief for several years.  Some of those years related to years no returns were ever filed, and other years related to years where the innocent spouse failed to pay the taxes that were properly reported on the returns.

The spouse in Mikels sought innocent spouse relief from the IRS before filing bankruptcy.  The IRS granted the innocent spouse relief as to the tax years when no tax return was filed and the IRS had assessed the tax deficiency. However, the IRS denied innocent spouse relief for the tax years that the tax return properly reported the tax liability.

The Mikels spouse filed bankruptcy and objected to the IRS’ proof of claim seeking payment for the properly reported tax liability.  The Mikels court overruled the spouse’s objection and allowed the IRS’ claim for the tax liability relating to the properly reported tax years.  The court ruled that “innocent spouse relief” is only available pursuant to 26 U.S.C. §6015 when the IRS assesses a tax deficiency and such relief is not available when the taxpayers merely fail to pay the tax.

PRACTICE POINTERS: Innocent spouse relief is a great tool for ex-spouses who were deceived by their self-employed ex-spouses who underreported net income and concomitantly underreported the total tax liability.  However, the tax professional must be able to spot when the IRS will grant such relief and when it won’t.  The simple rule is no relief when the tax was reported accurately, and relief may be available it the tax was underreported and the ex-spouse had no knowledge of the underreporting.

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Can a Bankruptcy Trustee Seize an Inherited IRA?

A Chapter 13 trustee cannot seize any IRA.  The worst the trustee can do is insist that the Chapter 13 plan provides to unsecured creditors an amount equal to the non-exempt value of the inherited IRA.  Whether the inherited IRA is exempt is a question of federal law for those states that have not opted-out of the federal exemptions (11 U.S.C. §522(b)) and a question of state law for those states that have opted-out.

A Chapter 7 trustee has greater powers than a Chapter 13 trustee.  A Chapter 7 trustee can seize and force the turnover of non-exempt inherited IRAs.  So the question is whether the inherited IRA is exempt or non-exempt from seizure.  This issue was addressed in In re Everett, 520 B.R. 498 (E.D.LA 2014).  In Everett, the taxpayer inherited an IRA from her ex-spouse and transferred the inherited IRA into a new IRA in her name. Later, a creditor obtained a $245,000 judgment against the taxpayer and claimed an interest in the inherited IRA.  Taxpayer responded by filing bankruptcy to discharge the debt. Taxpayer identified the inherited IRA as an asset and claimed the asset was exempt from collection.  Creditor objected to the exemption.

The Everett court found that the inherited IRA was NOT exempt under federal law.  The court cited the U.S. Supreme Court’s ruling in Clark v. Rameker, 134 S.Ct. 2242 (2014) that held inherited IRAs are not “retirement funds” within the meaning of §522(b)(3)(C) and therefore are not exempt assets.  The Supreme Court distinguished IRAs from inherited IRAs.  Inherited IRAs do not operate like ordinary IRAs.  Unlike with a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time without paying a tax penalty.  Indeed, the owner of an inherited IRA not only may but must withdraw its funds.  The owner must either withdraw the entire balance in the account within five years of the original owner’s death or take minimum distributions on an annual basis.  And unlike with a traditional or Roth IRA, the owner of an inherited IRA may never make contributions to the account.  Consequently, the Everett court found that the taxpayer’s inherited IRA cannot be exempted under federal exemption laws of §522(b)(3)(C).

The Everett court next noted that that Louisiana had opted out of the federal exemption statute of §522(b).  The court then analyzed Louisiana exemptions and found that the inherited IRA was not exempt under Louisiana law because the inherited IRA was not a “tax-deferred arrangement” within the meaning of the Louisiana statutes and therefore not exempt from the bankruptcy estate under Louisiana law.

Therefore, the Everett court reversed the lower court’s order denying the objection to taxpayer’s exemption, which will result in the taxpayer losing the inherited IRA to creditors.

PRACTICE POINTERS:  Determine whether the taxpayer’s state has opted-out of the federal tax exemptions.  If opted-out, then determine the exemption status of inherited IRAs under the state law of taxpayer’s residence.  This analysis will help you advise the taxpayer whether the inherited IRA would be protected from the Chapter 7 trustee’s attempt to seize the property or force a turnover of the property.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Can the Government Take My Tax Refund If I File Bankruptcy?

It is not uncommon for the state government to intercept and keep tax refunds for a current year as a method of offsetting unpaid past debts.  But what happens to the refunds if the taxpayer files bankruptcy before the government intercepts the refunds?  That issue was addressed in In re Johnson, 521 B.R. 912 (Bankr. W.D.AR. 2014).

In Johnson, the taxpayer anticipated receiving a tax refund from the IRS at some point after the bankruptcy case was filed.  The taxpayer listed the anticipated tax refund as an asset on the bankruptcy schedules with a corresponding exemption. The taxpayer owed money to the Arkansas Department of Workforce Services (“Government”) on the day the bankruptcy case was filed,  but failed to list the Government as a creditor holding a potential fraud claim.  Later, the Chapter 7 trustee entered a “no-asset” report indicating there were no assets for distribution to any unsecured creditors.  Ultimately, the court entered a discharge order.

The Government intercepted the tax return after the bankruptcy discharge had been entered, and refused to return the refund to the taxpayer.  The taxpayer responded by filing with the bankruptcy court a motion for contempt for violating the discharge injunction of 11 U.S.C. §524(a)(2).  Taxpayer argued that the Government was duty-bound to return the refund and later file an adversary to determine whether the Government’s debt was discharged. The Government opposed the motion for contempt and argued that the Government should have been notified of the bankruptcy filing and the lack of notice caused the debt to be rendered nondischargeable.

The Johnson court noted three key facts: (1) the Government had never received notice of the bankruptcy case before intercepting the refund; (2) the trustee had issued a “no-asset” report; and (3) the Government’s claim was based in fraud.  These facts triggered the applicability of 11 U.S.C. §523(a)(3)(B), which allows litigation to proceed at any time on the issue of fraud.  A creditor holding a fraud claim which was not notified of the bankruptcy filing is not restrained by the typical 60-day objection period of Bankruptcy Rule 4007(c).

Moreover, the Johnson court ruled that the bankruptcy court no longer had exclusive jurisdiction over the determination of dischargeability under §523(a)(2), (4) or (6).  Instead, the bankruptcy court shares jurisdiction with the state court. In short, the penalty to the taxpayer for failing to schedule the creditor holding a fraud claim is forfeiture of the right to enjoy exclusive federal jurisdiction and loss of the 60-day limitations period applicable in exclusive jurisdiction actions.

In short, the Johnson court rejected the taxpayer’s attempt to hold the Government in contempt for violating the discharge injunction.  Similarly, the court rejected the Government’s argument that the debt was rendered nondischargeable.  Instead, the court denied the motion for contempt and declined to hold the Government in contempt until a court of competent jurisdiction rendered a judgment on whether the Government’s claim for fraud was rendered dischargeable or nondischargeable by the bankruptcy discharge.

Practice Pointer:   Taxpayers should strive to list accurately all creditors by name and address. Taxpayers who fail to give a creditor proper notice could find those debts nondischargeable in a Chapter 13 case or an “asset” Chapter 7 case.  But, if a taxpayer discovers that a creditor holding a potential fraud claim was inadvertently omitted from an “no-asset” Chapter 7 bankruptcy case, then the taxpayer should file an adversary proceeding in the bankruptcy court seeking a determination that the claim was discharged by the bankruptcy.

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What Mental State is Required to be Guilty of Tax Evasion?

Some taxpayers do not pay taxes because of poor cash flow.  Other taxpayers employ elaborate schemes to evade paying taxes. A third category of taxpayers show an indifference to tax obligations and continue to live their lives without paying taxes—some of the latter taxpayers are very rich people!

The U.S. Court of Appeals for the Ninth Circuit determined what mental state is required to find that a taxpayers’s federal tax liabilities should be excepted from discharge under 11 U.S.C. §523(a)(1)(C) for willfully attempting to evade paying the tax.  In Hawkins v. Franchise Tax Board of California, 769 F.3d 662 (9th Cir. 2014), the Ninth Circuit concluded that “specific intent” to evade is required for the discharge exception to apply.

In Hawkins, the taxpayer enjoyed the trappings of wealth, including a private jet, expensive private schooling for the children, an ocean-side condominium in La Jolla, CA, and a large private staff.  Taxpayer was a successful capitalist who invested in tax shelters upon the advice of tax counsel.  The IRS audited Hawkins and challenged the validity of the tax shelters.  The IRS then disallowed the tax shelters and assessed taxes and penalties of $16 million.

Hawkins did very little to alter his lavish lifestyle after it became apparent that Hawkins was insolvent and their personal living expenses exceeded their earned income.  Later, Hawkins filed Chapter 11 bankruptcy and confirmed a liquidating plan of reorganization.  The IRS received over $3 million from the bankruptcy estate.  The plan provided for a discharge of all preconfirmation debts, but provided that Hawkins and the IRS could bring suit to determine if the tax debt was dischargeable by the bankruptcy.  Such a suit was filed.

The IRS’ argued that the tax debt should not be discharged in bankruptcy because Hawkins’ maintenance of a rich lifestyle after their living expenses exceeded their income constituted a willful attempt to evade taxes.  The bankruptcy court agreed, but the Hawkins court reversed and rejected the IRS’ broad interpretation of the word “willful” and adopted a narrow interpretation of “willful.” More specifically, the Hawkins court concluded that declaring a tax debt nondischargeable under §523(a)(1)(C) on the basis that the taxpayer “willfully attempted in any manner to evade or defeat such tax” requires a showing of specific intent to evade the payment of taxes.  Id. at 669.

The Hawkins court distinguished its ruling from the ruling of other circuits that have found income taxes nondischargeable if the taxpayer merely committed the evasive acts intentionally—even if taxpayer’s evasive acts were committed for a purpose other than evading the payment of taxes (e.g. payment of money to doctors for cancer treatment instead of paying IRS).  While the Hawkins court noted that other circuits used different semantics, the court noted  that most of the cases in the other circuits resulting in nondischargeability actually involved intentional acts or omissions designed to evade taxes.  Id. at 669.

The Hawkins court reversed the bankruptcy court and remanded for consideration of the facts in light of the new “intent to evade” standard.  Apparently the Hawkins court wanted the bankruptcy court to determine if Hawkins continuation of a lavish lifestyle after IRS assessment of $16 million was (a) an indifference to taxpayer’s duty to pay taxes, or (b) an attempt to evade paying the taxes.

Practice Pointer:   Some red flags indicating intent to evade paying taxes include: keeping double books, making false bookkeeping entries, destroying records, transferring assets to a third-party, and concealing assets.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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How Long Does a Bankruptcy Filing Stay on My Credit Report?

Some people say a bankruptcy filing stays on the credit record for 7 years and other say 10 years.  Who is right?  This issue was addressed by the U.S. Court of Appeals for the Seventh Circuit in Childress v. Experian Information Solutions, Inc., 790 F.3d 745 (7th Cir. 2015).  In Childress, the court found the Fair Credit Reporting Act requires a reporting agency to purge bankruptcy records 10 years after the bankruptcy filing date, but noted that the credit-reporting agencies voluntarily purge them after seven years instead.  Id. at 746-747.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can Bankruptcy Discharge Income Taxes Filed More Than 2 Years Before the Bankruptcy Filing?

Short Answer:  Yes, income taxes can be discharged in bankruptcy if the taxpayer satisfies all of the bankruptcy requirements.  One of the contested issues is whether tax liability relating to a late-filed return can ever be discharged.  Another issue is whether the paper filed with the taxing authority is deemed a “return” for bankruptcy purposes.  These issues were addressed in In re McBride, 534 B.R. 326 (Bankr. S.D.OH 2015).

Facts: The taxpayer filed multiple city tax returns for taxes imposed by the City of Kettering, Ohio (“City”).  Some returns were filed on a timely basis and at least one return was filed after the due date. The tax liability due on these returns was calculated in relation to the IRS tax liability.  This liability was dramatically understated as a result of the taxpayer’s scheme to minimize tax liability through a now discredited “abusive trust arrangement.”  The US Tax Court found taxpayer’s self-reported returns dramatically deficient and increased the tax liability substantially, which caused the City tax liability to be increased proportionately.

Argument: In response, taxpayer filed chapter 7 bankruptcy to discharge the tax liability more than 2 years after the original City returns were filed. Taxpayer then filed an adversary proceeding to determine the dischargeability of the tax and filed a motion for summary judgment to obtain a judgment.  City objected asserting that the taxes owed are nondischargeable under 11 U.S. C. §523(a)(1)(B)(i) because the taxpayer never filed qualifying “returns.”  City argued the documents filed do not constitute “returns” because one return was untimely and all of the tax documents significantly under-reported the taxpayer’s income.

Analysis: The McBride court was forced to resolve the issue. There, the court addressed the two competing arguments regarding whether a late filed return can ever be a “return” for bankruptcy purposes.  The McBride court noted that the hanging paragraph in §523(a)(*) attempts to define the term “return.”  However, the court found the statute’s definition unclear and begged the question “Is §523(a)(*) pointing to the definitional provisions in state or local tax law to define the term ‘return’ for §523(a) purposes or, instead, must the document satisfy all aspects of the relevant nonbankruptcy ta law, including filing requirements, in order to be a ‘return’?” (Emphasis added).

The McBride court considered and rejected City’s bright-line test adopted by the Fifth Circuit in McCoy v. Miss. State Tax Comm’r (In re McCoy), 666 F.3d 924 (5th Cir. 2012) and followed by the Tenth Circuit in Mallo v. Internal Revenue Service (In re Mallo), 774 F.3d 1313 (10th Cir. 2014) and the First Circuit in Fahey v. Mass. Dept. of Revenue (In re Fahey), 779 F.3d 1 (1st Cir. 2015).  This test looks strictly at the tax statute’s filing deadline and would render taxes nondischargeable if the return was filed even one day late.

Instead, the McBride court applied the simplest meaning to §523(a)(*)’s definition of “return” as it relates to the nondischargeability of income taxes. The court held that §523(a)(*) required the court to look to relevant nonbankruptcy law to determine what qualifies as an acceptable return under that law. The court believed that if a document filed with the federal, state, or local taxing authority meets the applicable tax code’s DEFINITION of an acceptable return, then it is a return under §523(a)(*) even if the document does not fully comply with all aspects of the relevant tax code.

When a formal definition of return in the applicable tax statute is absent, the court must look to another source for determining whether the taxpayer’s tax documents qualify as a return.  The Sixth Circuit applied a four-part test to determine whether a tax form qualifies as a tax “return” for bankruptcy purposes: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of the tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of tax law.  See Beard v. Commissioner, 82 T.C. 766 (1984) adopted by United States v. Hindenlang (In re Hindenlang), 164 F.3d 1029 (6th Cir. 1999).

The McBride court applied its analysis to the case and bar and concluded that questions of fact existed and these facts had to be determined before the Beard test could be applied.  Therefore, the court denied the taxpayer’s motion for summary judgment and allowed the parties to present evidence to determine if the tax returns filed with the City were “returns” for bankruptcy purposes.

Practice Pointer: File all tax returns and perform all other filing obligations on a timely basis.  Wait the two years after filing the tax returns (and meet all other requirements) before filing bankruptcy.  Then expect to battle the taxing authority if the returns were filed late or substantially understated the tax liability.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

How do I Sue the IRS for Taking Assets After my Taxes were Discharged in Bankruptcy?

A taxpayer can sue the IRS for collecting taxes eliminated in a Chapter 7 bankruptcy case—but not immediately.  So what are the rules and limitations?

That issue was addressed in In re Broos, 534 B.R. 358 (8th Cir. BAP 2015).  There, the taxpayer filed bankruptcy and obtained a bankruptcy discharge before the IRS levied the taxpayer’s assets and filed a Notice of Federal Tax Lien. The taxpayer filed an adversary lawsuit in the bankruptcy court and sought damages for violating the automatic stay and/or the bankruptcy discharge injunction. The IRS sought to dismiss the lawsuit because the taxpayer had failed to exhaust the “administrative remedies” before filing the lawsuit.

The Broos court agreed with the IRS. First, taxpayers can sue the IRS only to the extent the United States has waived its sovereign immunity per 26 U.S.C. §7433(a).  But, taxpayers may not bring a direct action for damages against the IRS until the taxpayer exhausts the administrative remedies provided in 26 U.S.C. §7433(d).  The Tax Code requires the taxpayer to adjudicate the issues before an administrative law judge and plead a case for damages; thus keeping the IRS out of court as much as possible.  There, the taxpayer can seek damages for the IRS’ willful violation of the bankruptcy automatic stay protections under 11 U.S.C. §362 and the bankruptcy discharge injunction under 11 U.S.C. §524.  See 26 U.S.C. §7433(e)(1).

What are the procedures for exhausting the administrative remedies?  The procedure a taxpayer must follow in order to exhaust the remedies under §7433(d) for violating the bankruptcy discharge is enumerated in 26 C.F.R. 301.7430-1 and 301.7433-2(e).  A litigant must file a written administrative claim for damages or for relief with the Chief, Local Insolvency Unit for the corresponding judicial district in which the bankruptcy petition was filed.  The claim must contain the taxpayer’s name, identification number, current address, current home and work telephone number, the location of the bankruptcy court in which the underlying bankruptcy case was filed, the case number of the bankruptcy case in which the violation occurred, a description of the violation and injuries, the dollar amount of the injuries, and the signature of the taxpayer or taxpayer’s representative.  26 C.F.R. 301.7433-2(e).  The taxpayer must then wait until the earlier of six months or the date on which the IRS has rendered a decision on the claim.

In Broos, the taxpayer failed to seek damages and administrative remedies before filing the adversary lawsuit in the bankruptcy court.  Therefore, the bankruptcy court dismissed the lawsuit against the IRS as premature.

Note that damages can never include punitive damages against the IRS for violating the automatic stay or bankruptcy discharge injunction.  Punitive damages are unavailable as a matter of law. 11 U.S.C. §106(a)(3).

Practice Pointer: Suing the IRS is very complicated.  The law forces claims to be addressed administratively within the IRS by an administrative law judge. Only afterwards can a taxpayer seek damages in the bankruptcy court for violating the Bankruptcy Code.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can I Sue IRS Employees for Collecting Taxes Eliminated in Bankruptcy?

IRS employees make mistakes like everybody else.  But the IRS employees have special protections that average citizens do not enjoy. So, what can a taxpayer do if the IRS wrongfully attempts to collect income taxes discharged in bankruptcy by levying assets or filing notices of federal tax liens?

That issue was discussed in In re Broos, 534 B.R. 358 (8th Cir. BAP 2015).  In Broos, the taxpayer filed bankruptcy and received a chapter 7 bankruptcy discharge long before the IRS attempted to levy the taxpayer’s assets and before the IRS filed a Notice of Federal Tax Lien.  The IRS was provided notice of the bankruptcy and presumably notice of the chapter 7 bankruptcy discharge.  Nonetheless, the IRS levied and liened.

The taxpayer filed an adversary lawsuit in the bankruptcy court and sought damages for violating the automatic stay and/or the bankruptcy discharge injunction.  The lawsuit named as party-defendants the individual IRS employees involved in the levies and liens.  The IRS opposed arguing that the employees should not be the named defendants and the IRS should be substituted as the proper party defendant.

The Broos court agreed with the IRS.  The court noted the general rule that a taxpayer may not sue the United States or any of its officers and employees without a waiver of sovereign immunity.  Congress provided such a wavier in 26 U.S.C. §7433(a) but only as to the United States and not as to its individual employees.  Individual federal employees may not be sued for actions taken in the performance of their official duties.  Any claims filed against the individual employees would be barred by sovereign immunity.  Thus, the court granted the United States leave to be substituted as the property party defendants because Congress had waived sovereign immunity as to it.

Practice Pointer: Name the United States, and not the “Internal Revenue Service,” as the proper party defendant.  Also, do sue the individual IRS employees who performed the objectionable acts because the employees are protected by sovereign immunity.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Will I Lose my Tax Refund if I File Bankruptcy?

Here’s a common fact pattern.  A taxpayer files bankruptcy in June of a tax year and receives an IRS tax refund in April of the following calendar year.  What happens to the non-exempt portion of the IRS tax refund?  The taxpayer would want to keep the refund, but the Chapter 7 trustee would want a turnover of the refund for the benefit of the unsecured creditors.

That issues was addressed in In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, the parties agreed that the taxpayer should be allowed to keep the portion of the tax refund representing income earned after the bankruptcy case was filed to December 31.  The IRS argued that the taxpayer should be allowed to keep the same percentage of the tax paid after filing bankruptcy to the total tax refund; so if 25% of the tax payments were tendered after filing bankruptcy, then the taxpayer would be allowed to keep the same 25% of the total refund.

The Mooney court, rejected the IRS’ approach and adopted a “pro rata by days approach.”  Id. at 428.  The court held that the refunds should be prorated to the date of filing based on the number of calendar days before and after the bankruptcy filing date.  So, since the taxpayer filed bankruptcy on the 177th day of the year with 188 days remaining, then the trustee would be allowed to seize the percentage of the total refund that reflects 177/366, or 48.49%.  Similarly, the taxpayer would be allowed to retain the percentage of the total refund that reflects 188/365, or 51.51%.

Practice Pointer:  File as early in the calendar year as possible if a taxpayer is expecting a large refund. An early filing preserves the argument that the income was earned after the bankruptcy filing and the maximum share of the tax refund would be protected by the taxpayer.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Are Estimated Tax Payments Paid to the IRS Protected from Seizure in Bankruptcy?

Yes, estimated tax payments made to the IRS immediately before filing bankruptcy could be protected from seizure by the Chapter 7 trustee, according to In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, an individual taxpayer tendered to the IRS $36,700 in estimated tax payments two days before filing Chapter 7 bankruptcy.  The Chapter 7 trustee wanted to seize those payments and filed a motion for turnover pursuant to 11 U.S.C. §542(a), arguing that the estimated tax payments were credits against the future tax liability and constituted “credits” that are property of the bankruptcy estate which are subject to turnover.  The taxpayer opposed the turnover motion and argued that the tax payments/credits are not within the taxpayer’s “control” because those payments can only be refunded by the IRS after the payments are applied to taxes due for the year in which the payments were made, citing Rev. Rul. 54-149, 1954-1 CB 159-60.

The Georgia bankruptcy court noted that the Eleventh Circuit in which it sits has never published a decision on the issue. But, the court noted that the Ninth and Tenth circuits have published conflicting opinions.  So the bankruptcy court analyzed both approaches.

Adopting the reasoning of the Tenth Circuit in the case of Weinman v. Graves (In re Graves), 609 F.3d 1153 (10th Cir. 2010), the Mooney court started its analysis by finding the tax credits were property of the bankruptcy estate.  But, the court noted that the Chapter 7 trustee succeeded only to the title and rights in the tax credits that the taxpayer had at the time the bankruptcy case was filed, nothing more.  The Mooney court believed the trustee’s interest in the tax creditors were limited to the same extent as a taxpayer’s interest in the application of a prior year tax refund, by the strictures of 26 U.S.C. §6513(d), which makes a taxpayer’s refund application election irrevocable.  A taxpayer would have no right to any cash refund of the estimated tax payments until their current tax liability is determined and then only if they are entitled to a further refund.

Finally, the court held that the bankruptcy estate’s interest in the pre-payment is limited to the taxpayer’s contingent reversionary interest in the pre-payment attributed to pre-petition earnings.  Stated differently, if the taxpayer is entitled to a refund after their current year tax liability was satisfied, then the Chapter 7 trustee is entitled to demand turnover of any amount of such refund attributable to the prepetition earnings.

Practice Pointer:  Tendering estimated tax payments to the IRS for the current year (or applying a tax refund from a prior year) prior to filing bankruptcy is a clever strategy to deplete non-exempt assets that would otherwise be seized by the trustee and distributed to the unsecured creditors.  Step two of the strategy would be to minimize the tax refund in the current year since the Chapter 7 bankruptcy trustee would be entitled to demand turnover of any amount of the refund attributable to the prepetition earnings. Taxpayers receiving a paycheck could reduce their tax withholdings in an effort to minimize the tax refund.  Self-employed taxpayers could seek to minimize refunds by minimizing net income from delayed income recognition and expedited expense recognition.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Does a Criminal Conviction Prevent a Taxpayer from Discharging Tax Debt?

Criminals who have been convicted of tax fraud or other tax crimes typically have tax liabilities.  But not all tax crimes are the same.  Some crimes relate to filing fraudulent tax returns with the intent to evade paying taxes.  Other tax crimes relate to willfully submitting to the IRS false returns, statements, or other documents that may or may not relate to any intent to evade paying taxes.  From a bankruptcy point of view, these crimes are not equal.

The question arises whether a taxpayer convicted of willfully submitting to the IRS false “returns, statements, or other documents” pursuant to 26 U.S.C. §7206(1) can discharge the related tax liabilities by filing Chapter 7 bankruptcy.  This issue was addressed in U.S. v Parker, 578 Fed.Appx. 669 (9th Cir. 2014).  In Parker, the IRS filed a summary judgment motion seeking to reduce to judgment the taxpayer’s income tax liability after taxpayer received a bankruptcy discharge.  The taxpayer objected claiming there was a triable issue of fact that precluded the entry of a summary judgment on the issue of bankruptcy dischargeability, namely whether the taxpayer ever intended to evade paying the tax. Taxpayer asserted that the tax conviction (and tax liability) resulted from the embezzlement of funds to save a business from bankruptcy and not to evade paying IRS tax.

The 9th Circuit Court of Appeals began its analysis by noting that a taxpayer’s discharge in bankruptcy may be excepted “for a tax… with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” 11 U.S.C. §523(a)(1)(C).  The government must demonstrate (1) a knowing falsehood; (2) an intend to evade taxes; and (3) an underpayment of tax.

The Parker court determined that the  26 U.S.C. §7206(1) criminal conviction proved conclusively that the taxpayer had satisfied the first and third element (“a knowing falsehood” and an “underpayment of tax”), but did not conclusively prove the second element (that the taxpayer had intended to evade the payment of taxes).  So the court denied the IRS’ motion for summary judgment because an intent to evade taxes creates a credibility determination that is prohibited at the summary judgment stage.  A trial is required to determine the taxpayer’s intent.

Practice Pointers: A tax professional must realize that not all tax crime convictions are the same.  The tax professional must review the specific elements of the crime committed.  Some criminal convictions necessarily would result in the denial of a bankruptcy discharge, while other crimes do not.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Are IRS Tax Liens Removed by Filing Bankruptcy?

An IRS lien can be eliminated in a Chapter 13 bankruptcy case, but tax liens cannot be avoided by filing a Chapter 7 bankruptcy case.

A taxpayer unsuccessfully attempted to avoid the IRS’ tax liens by filing chapter 7.  In U.S. v Parker, 578 Fed.Appx. 669 (9th Cir. 2014), the court found that a chapter 7 case discharged the taxpayer of personal liability for old taxes, but the prepetition tax liens on the taxpayer’s property remained enforceable after the discharge—citing the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992).

Practice Pointers: A Chapter 7 bankruptcy case is designed to eliminate personal liability, but not the lien against real estate or personal property.  A chapter 13 case would be a better strategy if the goal is to strip or avoid a lien.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Spouse Who Signs a Joint Tax Return Without Reviewing it be Denied a Bankruptcy Discharge?

Sometimes one spouse takes the financial reins and handles all the financial aspects of a marriage (like banking, buying cars, preparing tax returns, etc.) while the other spouse handles the day-to-day family issues (like cooking, cleaning, children, etc.).  It is not uncommon for the non-financial spouse to sign a tax return without reviewing it.  It is a matter of trust.  The non-financial spouse trusts the other spouse to prepare an accurate tax return.

In In re Birkenstock, 87 F.3d 947 (7th Cir. 1996), the court was confronted with the issue of whether a wife who signs a joint tax return without reviewing it can be denied a bankruptcy discharge of tax liability for “willful attempt to evade” taxes.  The Birkenstock court had no problem finding the husband to be a chronic tax evader who took extraordinary steps to willfully attempt to evade paying the taxes. The husband’s taxes were excepted from the bankruptcy discharge and survived intact at the conclusion of the bankruptcy.

The Birkenstock court had a more difficult time deciding whether the wife also willfully attempted to evade paying the taxes.  The court noted that the only relevant evidence upon which the bankruptcy court had determined that the wife had acted willfully was the fact that she had signed the joint tax return.

The Birkenstock court set out the rules for non-dischargeability of tax liability in bankruptcy. The court noted that a Chapter 7 debtor is typically granted a general discharge of all debts owed as of the bankruptcy filing date.  However, 11 U.S.C. §523(a)(1)(C) creates an exception to the dischargeability of income taxes when the taxpayer makes “a fraudulent return or willfully attempts in any manner to evade or defeat” the tax.

So the question in the Birkenstock case was what constitutes “willfully attempts … to evade or defeat” the payment of taxes.  The 7th Circuit held that §523(a)(1)(C)’s exception comprises both a conduct requirement (that the taxpayer sought in any manner to evade or defeat his tax liability) and a mental state requirement (that the taxpayer did so willfully).  The court found that a “willful” determination requires a taxpayer’s attempt to avoid tax liability to be voluntary, conscious, and intentional.  In other words, the taxpayer must both (1) know that she has a tax duty under the law, and (2) voluntarily and intentionally attempt to violate that duty.  The willfulness requirement prevents the application of the bankruptcy discharge exception to taxpayers who make inadvertent mistakes, reserving nondischargeability for those whose efforts to evade tax liability are knowing and deliberate.

After reviewing the law and apply the law to the facts, the court ruled that the bankruptcy had erred in finding the spouse had willfully attempted to evade the tax liability.  The only evidence presented at trial regarding the wife’s willfulness was the fact that she had signed the tax returns.  Therefore, the bankruptcy court order was reversed and the wife was granted the bankruptcy discharge as to the tax liability.

 

Practice Pointers:  A spouse should consider not filing a joint tax return if the spouse has any reason to believe the other spouse may be filing a fraudulent return or may be willfully evading the tax liability.  Instead, a spouse should consider filing a separate tax return, especially if the spouse has little to no income as the spouse in Birkenstock.  The wife in Birkenstock would not have had any tax liability, because she did not work, had she filed separately.  The husband would have had all the tax liability and the wife would not have had to worry about any court ruling that her share of the tax liability was nondischargeable.  There are some tax disadvantages by filing separately, but none of the those disadvantages would compare to the disadvantage of the wife being held jointly and severally liable for the husband’s tax liability that could later be deemed nondischargeable in bankruptcy.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

What is the Effect of Crossing-Out the “Penalty of Perjury” Verification on an IRS 1040 Form?

The IRS 1040 Form concludes with a taxpayer’s obligation to sign the return under penalties of perjury, and to declare that the taxpayer has examined the return and accompanying schedules and statements, and state to the best of the taxpayer’s knowledge and belief, they are true, correct, and complete.

But what happens to a taxpayer who strikes or otherwise scratches-out the verification?  A taxpayer scratched-out the verification and suffered the consequences in United States v. Moore, 627 F.2d 830 (7th Cir. 1980).  In Moore, the taxpayer who scratched out the verification on tax returns filed over several years was indicted for tax evasion for failing to file income tax returns.  The IRS did not consider the unverified tax returns as tax “Returns.”

The court noted the taxpayer’s duty to sign a return that verifies its accuracy under penalties of perjury.  The Moore court found that debtor’s failure to verify the return under penalty of perjury resulted in the return not being deemed a “Return” for tax purposes. Id. at 834.

Practice Pointers: The best strategy is for the taxpayer to hand-deliver the tax returns to an IRS office and to have an extra copy hand-stamped “Filed” by the IRS representative.  A taxpayer should ask that both page 1 and page 2 of the Form 1040 be stamped so that the taxpayer has proof that the return was signed.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.